Bubblelicious Margin Debt 1
Margin balances have been making new all time highs for several months now. Accordingly, market participants have pointed to this as yet another piece of evidence that the US equity market is in a bubble. What really is the significance of high margin balances, and what do they tell us about the future?
The chart above illustrates how much margin debt traders and investors have taken on in their margin accounts. As of March 2021, this number stands at approximately $800 billion.
While that is a very large number, it doesn’t mean much on its own, and some kind of context is needed. From the same chart, today’s margin debt is about twice what it was before the onset of the Great Financial Crisis in ‘08; and slightly more than 2.5 times the amount before the bursting of the Dot Com bubble.
Naturally, these comparisons draw immediate alarm and cries of “bubble!” from those hearing about them for the first time. But is this reaction justified?
Considering that stock market conditions in 2000 are commonly thought of as synonymous with a bubble, and those in 2008 were similar (at least in housing/mortgage/financials); then logically, 2021 has to be yet another equity market bubble. Other pieces of evidence corroborate this, such as the Buffett indicator and the CAPE.
Now, what about the alarm the term “bubble” causes? Put another way, how much does classifying a market as a “bubble” really matter?
The unfortunate truth is that it really doesn’t matter that much. It is not as if a magical threshold exists where the market peaks and sells off violently after a certain number of individuals consider it to be in a bubble. On the contrary, and very counterintuitively, the more people there are who consider the market to be in a bubble, the more likely it is to keep going higher!
Why? Because when humans see their friends and peers getting rich, they want in too! It’s a combination of the psychology of crowds, a.k.a herd behavior, and the optimism bias, where people mistakenly think that bad outcomes will occur to everyone else but themselves.
Of course, in this case, bad outcomes would mean selling out of their long equity positions before the market crashes. However, if you stop and think about it, this means that they would have to somehow be able to ascertain when the market will peak before it actually does!
Needless to say, this is extremely difficult to do, and one’s ability to sell a market’s top is hugely reliant on luck. Whether a market is considered to be in a bubble or not almost certainly does not factor into one’s ability to manage this feat.
Also, in the same vein but from the opposite perspective, a market’s classification as a bubble does not give short sellers extra insight into timing a market’s peak. As such, whether a market is labeled a “bubble” or not does precious little to help longs and shorts time their trades, and is of little practical consequence.
To be continued…
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