Is Margin Debt An Indicator That The Market Might Correct?

| About: SPDR S&P (SPY)

Summary

While elevated margin debt in the past was a proxy for a market correction, today it might not mean much.

Reason being that margin debt has to be taken into context of current market capitalization, as well as where current interest rates are.

When looking at the above two elements closely, margin debt probably does not mean anything today.

A recent article by Mark Hulbert shows an interesting chart of total margin debt on the NYSE.

Click to enlarge

Some commentators think that this might be a good indicator of a market correction or even a crash.

As Mark wrote:

According to some, that means a bear market is way overdue. That's because margin debt typically peaks in advance of the stock market itself. In 2007, for example, margin debt peaked in July, three months before the bull market topping out in October. As Wolf Richter of the Wolf Street investment blog bluntly put it: Margin debt "has a bone-chilling habit of peaking right around the time stocks crash."

Now on the surface this thesis seems correct; however, I have doubts if margin debt is a good indicator for a bear market or even correction, because other data needs to be taken into consideration.

One such consideration is market capitalization. Please look at the chart below that depicts the total market cap of all listed U.S. companies (NYSEARCA:DIA) (NYSEARCA:IWM) (NASDAQ:QQQ) (NYSEARCA:SPY).

US Market Capitalization of Listed Companies Chart

US Market Capitalization of Listed Companies data by YCharts

While total margin debt peaked at almost $300 billion in 2000, the reality is that today the market cap of all stocks listed on U.S. exchanges is almost double. So in other words, while $280 billion in margin debt might have been a big sum in 1999, it's not that big today.

Another parameter that needs to be taken into consideration is the current level of interest rates (NYSEARCA:UUP). As the Financial Times wrote recently:

The value of negative-yielding bonds swelled to $13.4tn this week, as negative interest rates and central bank bond buying ripple through the debt market.

The universe of sub-zero yielding debt - primarily government bonds in Europe and Japan but also a mounting number of highly-rated corporate bonds - has grown from $13.1tn last week, according to figures compiled by Tradeweb for the Financial Times.

So in other words, even if the above charts were adjusted for today's market cap, we might not be in a "margin debt bubble" if one considers the state of yields.

In the old days money flowed from equity to fixed income back and forth, depending on interest rates and economic growth.

Today, however, with very low interest rates everywhere, money only goes to sovereign debt for safekeeping purposes and only as a last resort. Yes, there are still corporate bonds out there, however, has anyone seen the yields?

Look at this very interesting chart from the WSJ:

Click to enlarge

As you can see, negative yields are taking over the sovereign debt market. In fact, Switzerland's (NYSEARCA:EWL) rates are negative from 1-year to 50-year bonds. In Germany (NYSEARCA:EWG) all expect the 30-year is negative, as so is in Japan (NYSE:JEQ). Sweden (NYSEARCA:EWD), the Netherlands (NYSEARCA:EWN), France (NYSEARCA:EWQ), Spain (NYSEARCA:EWP) and even the Italian (NYSEARCA:EWI) short dates bonds are negative (you read correctly, Italy).

I am not here to tell why we have these negative interest rates - that might be the topic of another article - just that they are. And in my opinion, it is one of the reasons why margin debt does not matter like it did in the past. Because money that wants some kind of return has nowhere else to go but equities, no matter what global or country specific growth rates might be.

This does not mean that markets cannot correct. In fact they can for a variety of reasons; however, when it comes to looking at margin debt for a proxy of market correction, I think that it is irrelevant today.

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.