Buy The Dip—Not This Time!

“Today’s Stock Investors are Paying off Margin Loans at a Record Pace”

Besides superior long-term performance, stock investing offers many advantages not found in other asset classes.

Through margin loans, short sales, and stock options, even a small investor can increase their gains during bull markets and protect value during bear markets.

A long-standing example of the financial flexibility in public stock ownership is the convenience of borrowing on the value of one’s investment account. Similar to home equity loans, margin debt is issued by financial custodians and backed by the equities held in an investor’s brokerage account. In exchange for paying variable-rate interest charges to brokerage firms, investors have easy access to their account equity by either withdrawing funds from the account or buying additional stocks without having to deposit more funds.

Historically, borrowing on margin is popular with sophisticated investors by giving them the potential to gain incredibly high rates of return on investments in a bull market, as long as, they pay off margin by selling stocks early in bear markets to defend the profits.

This pattern can be seen in the following chart. Margin use typically expands during long-running stock market expansions and contracts as market volatility increases.

Chart 1: NYSE Margin Debt Outstanding (1929 – Present)

Monitoring NYSE’s total margin debt outstanding is an effective way to track the underlying strength of the market. As a general rule, if the figure is above its 12-month moving average (red line), the market advance is backed by a healthy expansion of credit as buyers purchase more shares. However, credit usually contracts before a major market correction has savvy investors pay off their stock loans. If the figure drops below its 12-month average (red line) – watch out!

For example, during the market tops of 2000 & 2007 investment credit began to contract months before the stock market peaked and continue to contract throughout the bear markets to follow (see chart).

Chart 2: NYSE Margin Debt Outstanding (1990-Present)

The same situation is happening today. After hitting a record level of nearly $1 trillion in NYSE total margin loans outstanding last October, it has contracted 20%! A faster pace than during the Great Recession of 2008.

Chart 3: NYSE Margin Debt Outstanding (2019-Present)

While no indicator is perfect at predicting the future, this situation should give stock investors a moment of pause. For now, it might be better to “sell the bear rallies” and be defensive until the credit conditions improve.