StockWatch
Living on the Margin
The stock market in February gave at least some hope to the bulls who believe that the January 22 low will be the final bottom of the correction that began last October. The Dow Jones Industrial Average, at one point, rose to a level that was a thousand points higher than where it closed on January 22, in fact.
The bears, however, received some fresh ammunition of their own during February, courtesy of a report released by the New York Stock Exchange in January on margin debt of its member firms -- the total amount that the customers of those firms have borrowed to purchase securities. The January total is some 14 percent lower than the comparable number from last July, when margin debt hit a record high.
This is bearish, according to any number of analysts, because it supposedly is a reliable indicator of a major bear market whenever margin debt is trending downward for more than a month or two.
In fact, this supposition is so widely accepted among many intelligent analysts that I almost didn’t bother to confirm whether it has strong support in the historical data.
I’m glad I, nevertheless, decided to check it out.
Consider what I found upon feeding into my PC’s statistical software the monthly margin debt data provided by the NYSE, which dates back to 1959. Because the total value of all publicly traded stocks has gone up over the last five decades, I couldn’t focus on the raw amount of such debt. So, I had to focus on relative values of the NYSE data series.
I did this in two ways. First, I focused on margin debt as a percentage of the total market cap of all publicly traded stocks. I also looked to see how any given monthly reading compared to the 12-month moving average. I then compared these various relative values to how the stock market performed over the subsequent month, quarter, six months, and one- and two-year periods.
I didn’t find very much that was even marginally statistically significant. That is, from a statistical point of view, there was very little to distinguish between the stock market’s performances following periods of high margin levels and those with low levels, as measured by percentage of total market cap. Likewise, there was little to distinguish between the market’s average performance following periods when margin debt was above its 12-month moving average and when it was below.
One result that was particularly revealing came after I divided the sample into two halves. I found that the stock market’s performance following high and low margin levels was just the reverse in the first half of the sample period than in the second.
Why would I find such a tenuous relationship between margin trends and the stock market? I suspect that at least part of the answer is provided by what Norman Fosback wrote in the mid-1970s in his classic investment book, Stock Market Logic. Fosback, of course, has also been the editor over the years of a number of different investment newsletters, the most recent of which is Fosback’s Fund Forecaster.
Fosback, in effect, argued that margin traders possess two distinct traits that often counteract with each other. On the one hand, he writes, “Margin traders are always most extended at market tops when they should be less willing to carry large margin debt balances. Similarly, at important market troughs, when they would be heavily invested in common stocks, their margin account balances are invariably quite low.”
From this perspective, of course, lower levels of margin debt are not necessarily bearish.
But, on the other hand, according to Fosback, margin speculators also “exert a very profound impact on the course of market trends. When stock margin debt is rapidly expanding, margin speculators are aggressively buying on balance and stock prices work their way higher from the force of their activity. When stock margin debt decreases, representing net selling by margin speculators, stock prices are generally driven lower.”
From this alternate perspective, of course, margin debt’s recent downtrend is worrisome. No wonder my statistical tests failed to find strong statistical support for the notion that recent margin trends are bearish.
The bottom line? Declining margin debt does not appear to be the threat that many assume it to be.Mark can be contacted via email at mhulbert@marketwatch.com.
