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Economist Steve Hanke of the CATO Institute recently penned an excellent critique of Ben Bernanke's time at the Federal Reserve. Many Bernanke critics have derided potentially inflationary policies of the Fed, but Hanke has been even more critical of deflationary policies that restrict access to credit, most notably the Dodd-Frank financial reform. What I particularly like about Hanke's analysis is that he focuses on both sides of the equation and how it's creating a reality that is much more complex than meets the eye.

Nothing sums up the dichotomy of Federal government and Federal Reserve policies like margin debt figures. Tight regulatory policies, such as Dodd-Frank, are limiting access to credit to middle income prospective homebuyers, which is harming residential mortgage lending. Yet, loose monetary policies, such as quantitative easing, are encouraging reckless lending in other areas.

In December 2013, NYSE margin debt was at the 5th highest monthly level since the data has been recorded. As a percentage of GDP, it is now at 2.58%, just a hair behind the 2007 peak of 2.62%, and not too far behind the all-time record set in 2000 at 2.73%.

(click to enlarge)

Given the market retreat in January, it's completely possible that this figure has come down a bit since then, but the historically high levels of margin debt should be a cause for concern. It's simple to note that the other two surges in margin debt over the past half-century have preceded major stock market crashes. Margin debt peaked at 2.73% of GDP in March 2000, and then at 2.62% of GDP in July 2007. The March 2000 peak came a mere five months before a major market correction, while the 2007 peak preceded a significant correction by three months.

There's a very high correlation between margin debt and the S&P 500. The chart examines this relationship, by plotting margin debt as a percentage of GDP versus an inflation-adjusted S&P 500 index.

(click to enlarge)

These figures, alongside of historically high corporate profit margins would have me a bit concerned, in spite of the sanguine economic forecast for 2014. Indeed, I'm also of the view that there are a lot more major macroeconomic issues out there than often thought, with China's asset bubble leading the way. I wouldn't, however, ignore Italy's struggles, the Puerto Rican debt crisis, Dodd-Frank's new lending restrictions in 2014, state pension problems in the US, or a host of other issues brewing beneath the surface.

In spite of the modest January retreat, this is a market with above-average risks, and below-average compensation for those risks. There are still some good buys out there, but I view it as a great time to be well-hedged. The high margin debt levels are just one of many factors that make me skeptical right now.

Source: High Margin Debt And Quantitative Easing