Record High Margin Levels Will Accelerate Coming Market Correction

APR 24, 2018

Margin is wildly risky. No two ways about it. Warren Buffet “offers his strongest argument” against using it.

But in this heady market, with investors drunk on speculation, it’s at record high levels, and it will be a key component in a massive, blink-of-an-eye stock market decline. When brokerages are selling your positions with zero regard for getting the best prices and algorithms providing bids know this, liquidity can vanish in an instant.

It’s the perfect downside accelerant for a market in sharp decline, and we have seen nothing resembling a mass margin call from levels that have risen sharply (exactly as they did prior to the last three market corrections).

There is nothing like a good shot of leverage to fire up the stock market. How much leverage is out there is actually a mystery, given that there are various forms of stock-market leverage that are not tracked, including leverage at the institutional level and “securities backed loans” offered by brokers to their clients.

But one type of stock-market leverage is measured: “margin debt” – the amount individual and institutional investors borrow from their brokers against their portfolios. Margin debt had surged by $22.9 billion in January to a new record of $665.7 billion, the last gasp of the phenomenal Trump rally that ended January 26. But in February, as the sell-off was rattling some nerves, margin debt dropped by $20.7 billion to $645.1 billion.

In January, days before the sell-off began, FINRA warned about the levels of margin debt. It was “concerned,” it said, “that many investors may underestimate the risks of trading on margin and misunderstand the operation of, and reason for, margin calls.”

Investors might not understand that their broker can liquidate much or all of their portfolio “under unfavorable market conditions,” when prices are crashing. “These liquidations can create substantial losses for investors,” FINRA warned.

This is why leverage such as margin debt is the great accelerator for stocks on the way up as it creates new liquidity that goes into buying stocks. And this is also why margin debt is the great accelerator on the way down, when forced selling kicks in and liquidity just disappears.

ORIGINAL SOURCE: An Orderly Unwind of Stock Market Leverage? by Wolf Richter at Wolf Street on 4/23/18