Margin of error

Last week one of our readers sent in a note asking about margin lending in the stock market. In simplest terms, “margin” is a loan that allows an investor to use his or her stock portfolio as collateral. As the stocks in the portfolio move up the amount an investor can borrow increases, but if stocks move down the amount an investor can borrow decreases. Therefore the amount available to borrow is related to the value of stocks in the portfolio. For that reason, margin can be used to increase portfolio returns in a rising market, but can have an equally negative effect in a falling market.

Some investors have been worrying lately about the total level of margin lending in the market. Thankfully the New York Stock Exchange keeps a public record of this data. One blogger has been regularly updating the chart below, showing that margin lending has now superseded levels we last saw in 2001. Some fear that the amount of margin lending is a sign of froth in the market, that the market is thus overvalued, and that investors have extended themselves into buying securities they might not be able to afford.

Understandably, the chart above looks worrisome. However the good news is it’s a bit of an optical illusion, like this. The peaks are coincident, but not predictive. The truth is that margin lending doesn’t tell us anything about future stock market returns. Here’s why:

If we take into account all margin lending data available going back to about 1950, we see that the total amount of margin is roughly proportional to the total value of the stock market over time. So when the market goes up, margin goes up and vice versa. Looking at the total history of margin lending in the chart below, we see that the total value of margin has increased through history, just as the total value of the stock market has increased through history. That means the absolute level of margin has no predictive ability when it comes to future stock market returns. There’s no magic number that shows how much is too much.

But what about the relative level of margin? If we measure the total margin as a percentage of the total value of the US stock market, might we find a warning sign there? The chart below shows that relationship.

We clearly see that margin as a percentage of the overall stock market (blue line) has stayed within a range of about 0.50% to 2.00% over time. At the stock market peak in 2001, margin was about 1.5% of the value of the market. At the peak of the market in in 1972, margin was only 0.70% of the value of the market. Again, there’s no magic number telling us how much is too much. Therefore, measuring the relative amount of margin also shows no predictive ability to find tops or bottoms in the stock market.

Some readers will notice an upward trend in margin lending since 1990. Although we can’t say for certain, it’s likely due to several factors. First, the cost of debt has gradually declined since 1990, making it cheaper to use borrowed money. Therefore it makes sense that borrowing would rise. Second, competition between the brokerage firms that do the lending has increased over time, encouraging better lending terms and better systems to manage the margin lending exposures. Finally, margin lending was more of a side-pocket business through history. But over the last thirty years it has developed into a fully-fledged business line for banks and large institutions such as pension funds. Such large holders of pooled securities are able to generate substantial profits today through lending.

To summarize, time spent worrying about margin is better spent looking for great companies at low prices. Evidence shows us the relative and absolute level of margin debt has zero predictive ability, and should not be used as a measure of market health. 


Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.