With margin debt recently starting to subside, one might think investors have reason to feel confident. This might ring true if it weren’t for the fact that margin debt was sitting at a record high, greater than that during the Global Financial Crisis and the Dot Com bust. Given the tendency for this indicator to heighten market volatility due to an overexposure to debt amongst investors, the outlook is certainly anything but rosy.
One of the most notable indicators to assess the outlook for the market has been the level of margin debt compared with GDP. When the former is at a notable level compared with the latter (approximately 2.5%), the belief is that traders have become ‘greedy’. What’s concerning, is that margin debt recently exceeded this level, approaching just shy of 3%. This indicator is supported by its highly negative correlation with the market’s future performance over the next 3 years, whereby ‘greedy’ traders prompt an exit from the market – in this instance, estimates point to a decline in the market of about 35% over the next 3 years.
Across a shorter horizon, the indicator to observe closely is the nominal value of margin debt compared with its 12 month moving average. The presence of a decline from a major peak, as well as a negative rate of change in margin debt over a 12 month period, are viewed as the effects of a bear market. When one views the respective charts, they can see that these movements have already commenced.
With these indicators signaling a bleak outlook, could we see a sharp fall in the markets over the coming months?