by Jesse Felder at The Felder Report
Back on May 6th, as the stock market was pushing to new highs, I argued here that, “record-high margin debt should make you more cautious,” toward the stock market. At the time, it was popular to dismiss the idea that the level of margin debt, both absolute and relative (to GDP), should mean anything at all. Since then, stocks have fallen hard, along with margin debt levels, and the message it sends is even more meaningful today.
The simple reason I believe margin debt is a valuable indicator is that at extremes it is a very good measure of potential supply and demand for stocks. When margin debt is very low it tells us there is a lot of potential demand out there for stocks. Conversely, when it’s very high it signals that there is very little potential demand left and plenty of potential supply. If you believe supply and demand are the key to prices then this measure is something you should watch very closely then.
Recently, we hit record-high levels of margin debt, on both an absolute level and in relation to overall economic activity. I like to look at margin debt relative to GDP because it is a simple way to measure the popularity of financial speculation relative to overall economic activity. When this measure is very high, it tells me investors are highly interested in speculating in equities.
What’s more, this measure of margin debt-too-GDP has had a very high negative correlation to future 3-year returns in stocks over the past 20 years or so. When levered financial speculation as a percent of overall economic activity rises above 2.25% returns over the coming 3-years have been sharply negative.
What concerns me the most today is that after recently reaching this high-water