Sunday, October 28, 2007

Stock Margin Debt: Are We Past the Bull Peak?

This is an update to a prior post, which looked at margin debt as a sentiment indicator. That post found that annual rates of change in margin debt closely tracked cyclical highs and lows in stocks, and my subsequent post found a tendency for changes in rates of margin debt to lead market tops. That latter post also found that annual returns in stocks tended to be best when margin debt was neither growing nor contracting at rapid rates.

As we made our market top in July, the annual rate of change in margin debt soared to over 67%. Since 1970, we have registered only two higher readings: over 70% in early 1984, prior to a drop of about 15% by July of that year; and over 90% in April of 2000, prior to the multiyear bear market. Interestingly, since the July peak, not only has the annual rate of increase in margin debt declined (to about 40%), but the absolute level of debt has declined by over 15%.

What that tells me is that we've passed a peak in bull market sentiment. If investors are pulling back from stock margin debt the way they're pulling back from other kinds of debt in credit markets, this places a limit on buying power. And, at least in the past, that has also placed limits on prospective market gains.