Margin Debt Peaks May Indicate End Of Cyclical Bull Market

|
 |  About: SPDR S&P 500 Trust ETF (SPY)
by: Praveen Chawla

Summary

Margin debt peaks and market peaks occur close together.

Debt build-up drives bullish speculation and vice versa. There is a strong feedback loop between the two.

Sophisticated market players may be reducing margin debt in advance of market peaks thereby providing a leading indicator of a bull market rolling into a bear market.

The following chart shows S&P 500 (NYSEARCA:SPY) in relation to margin debt data from 1960 to present. (Margin debt data is published by NYSE.) The scales are % change since 1960. As you can see while the S&P 500 has climbed nearly 3500%, margin debt has climbed nearly 15000%. (These are nominal values and not inflation adjusted).

Click to enlarge

In this retrospective observational study I looked at the relationship between growth of margin debt and S&P 500 market peaks. Bullish speculation drives stock market to new highs. Speculators' use of margin loan increases in their enthusiasm to goose returns. Margin debt provides the "dry powder" for the stock. My thinking is that astute speculators recognize irrational exuberance and start to pull in leverage. This may be a self-reinforcing phenomenon - which in turn brings the market down. My hypothesis is that peak of margin debt is a leading indicator of stock market peak in a few months.

In the charts below, I look at the peak of cyclical bull markets followed by bear markets (declining at least 20% from the last peak) from 1960 onwards to see if my suspicion is correct.

1961 peak

The economy was expanding, but the Bay of Pigs fiasco of April 1961 and Cuban Missile Crisis of October 1962 sparked Cold War jitters and a brief bear market.

As can be seen in the chart below margin debt peaked in December 1961 coinciding with the market peak a couple of weeks later. If investors had taken the cue and reduced exposure they could have avoided the bull trap over Feb. and March 1962 before the selling started in earnest.

Click to enlarge

1966 Peak

This was the nifty fifty era.

The chart below shows that margin debt peaked in November 1965 about three month prior to the S&P 500 peak in February 1966 and six months prior to serious selling in May 1966.

Click to enlarge

1968 Peak

As per chart below margin debt peaked in June 1968 well in advance of S&P 500 peak Nov 1968.

Click to enlarge

1973 peaks

Margin debt peaked in December 1972 only one month prior to market peak in Jan 1973. Again even if investors failed to get out at the peak they had ample warning to avoid the bull trap in October 1973.

Click to enlarge

1980 peak

Margin debt kept on climbing till July 1981, in spite of the market peaking in November 1980. The subsequent drop in margin debt coincided with the sharp drop in the market over the summer and fall of 1982.

Click to enlarge

1987 peak

Again, margin debt provided no advance warning prior to Black Monday in October 1987. While the market peaked in August 1987 margin debt peaked in September 1987.

Click to enlarge

2000 Peak

Margin debt peaked in March 2000 while the market had a relatively flat peak from March 2000 to September 2000. In hindsight, there was adequate warning for investors to avoid the subsequent slaughter.

Click to enlarge

2007 Peak

Here again, margin debt peaked in June 2007 while the market did not peak until Oct 2007 providing investors plenty of time to get out and avoid the mid 2008 bull trap.

Click to enlarge

2014 ?

Margin debt reached a new record in Feb. 2014 and then trended down over the subsequent 3 months before rebounding in June as speculators responded to continued strength. It will be interesting to see if the July update would show a new record or will it roll over indicating a coming correction or bear market. It margin debt fails to breach the February 2014 high then it will be time to prepare for a bear market.

Click to enlarge

Conclusion

My retrospective look at the above charts indicates that margin debt peaks may provide a leading indication of bull markets rolling over into a bear market. Most of the bear markets (except in 1980s) were preceded by margin debt declines. However since NYSE releases margin data with 2 - 3 months lag, an observant investor may not avoid the start of a bear market but may avoid a bull trap which typically shows up a few months after a bull market peak. Please note that I did not study false positives generated by the margin debt signal. This is probably a topic for another article.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.