Last week, I wrote an article showing that the S&P 500 (NYSEARCA:SPY) is trading at a historical high valuation. In fact, the current P/E is at 25.09 (when the historical average is 15.61), the Shiller P/E is at 26.93 (when the historical average is 16.69) and current price-to-sales is at 1.92 (when the available historical average is 1.48). For the S&P to trade at its historical average, it would need to correct between 23% and 38%, depending on the metric used.
In another article, I showed that attempts to justify current equity valuations with the fact that the earnings yield is higher than the Treasury yield or through the idea that equities offer a higher dividend yield than Treasuries are both flawed.
In both articles, I explained that this bubble is being fueled by the Fed's (and other Central Banks') ultra-loose monetary policy. In this regard, normalization of monetary policy poses a big threat to current equity prices (as well as real estate, fixed income, commodity and all other asset classes).
Today, I'll address another worrying indicator for stocks: the current high level of margin debt.
What is margin debt?
If you already know this, feel free to jump to the next chapter.
Let's say you want to buy 1.000 share of a stock for $10 each. If you buy them with your own money alone, you would need $10.000 to make the purchase. Alternatively, you can ask your broker for a $5.000 loan, and in that case, you would only need to invest $5.000 of your own money. The $5.000 loan is margin debt.
Investors use margin debt to amplify their returns. Let's say the stock price goes up from $10 to $15. If you used your own money alone, you would get a 50% return: $15.000 / $10.000 - 1. However, if you bought the shares with a $5.000 loan, your gain was 100%: ($15.000 - $5.000) / ($10.000 - $5.000) - 1. This example doesn't include interest paid on the $5.000 loan over the period you owned the shares.
Of course, there's always a downside. Let's say the stock price goes down from $10 to $5. If you used your own money alone, you would lose 50%: $5.000 / $10.000 - 1. However, if you bought the shares with a $5.000 loan, you would lose all your capital: ($5.000 - $5.000) / ($10.000 - $5.000) - 1. Again, this example doesn't include interest paid on the $5.000 loan over the period you owned the shares.
If the shares fall below $5, you would have a margin call that requires you to reinforce the collateral in your account. If you don't, your broker is forced to close your position so that he can get the money of the loan back.
The key message I want you to retain from this explanation is that when there's a large amount of margin debt, any correction is likely to trigger several margin calls and force further selling (which could trigger even further forced selling). In fact, the bigger the amount of margin debt, the higher the likelihood of a healthy correction turning into a crash due to forced crowd selling.
What is the impact of margin debt on equity prices?
When margin debt is increasing, traders are investing more money than they personally own, so stocks move higher.
Likewise, if margin debt is decreasing, traders are taking out of the market at least the money from the loans they asked for (but probably also their own personal money), so stocks move lower. This can be a voluntary decision or be forced by margin calls.
That positive correlation can be seen in the following graph that puts together the S&P 500 index in blue (left index) and margin debt in red (right index).
The graph above includes information until the end of July 2016, because the NYSE did not yet deliver data for the month of August. Still, it seems that once again the summer recovery is being boosted by an increase in margin debt. In the month of July alone, margin debt increased $27 billion to $474.5 billion, which is the highest level registered so far year to date.
As Warren Buffet once said, "when the tides go out, you discover who's swimming naked". Clearly, many investors are swimming naked, and that poses a problem not only to them, but to all of us.
Nobody knows whether investors will take more loans to buy equities or if they'll do the opposite. There's no way one can predict that. However, we can be reasonable and say that as margin debt is at extremely high levels today, a healthy market correction could turn into a crash due to forced crowd selling. So, be safe.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.