Sign of a Bear Market
Do you think that stocks are a great investment today? If the answer is yes, you are not alone. A hallmark of the ending of bull markets is extreme optimism. Now I know that sounds counter-intuitive. Wouldn’t everyone being positive be a good thing? Unfortunately, that is not the case. There is an old saying from economist and writer Humphrey O’Neil. He says when everyone thinks the same way everyone is wrong.
Historically speaking, everyone is over the top enthusiastic right before a bear market starts. It was that way in 2000 and 2007. What about today? Investor sentiment (being positive) is at levels not seen since 1987. We all know what happened in 1987. The second biggest crash in the history of the stock market.
Now I can add to that number. Margin debt is at 513 billion dollars which is an all time high. Margin debt is particularly important to follow because it is typically at it’s highest right before bear markets start. When investors are the most optimistic they borrow money against their brokerage accounts and then invest it which creates margin debt.
February data shows that margin debt is at an all-time high. It is one of the more riskier strategies to invest because margin debt can’t exceed a certain percentage of an account. Thus, if stocks are declining and the value of a margin account declines then investors are forced to sell stock to keep the percentage of margin debt in line with regulations. If you have a high percentage of people selling stock to satisfy the percentage of margin debt, then you just have more selling which creates more decline. It is a dangerous loop and one of the main ingredients to the 1929 stock market crash.
Does record margin debt predict a bear market? No, it is just important to know that record levels of margin debt are typically present before a bear market starts.