Blog - Investing Notes

October 21, 2008 - Update: Margin Debt as a Stock Market Indicator

In a post at TraderFeed, Brett Steenbarger noted that long-term changes in margin debt may signal major stock market turning points. Could margin debt serve as an intermediate-term indicator based on either momentum (with an increase in margin debt signaling a higher stock market) or contrarian reversion (with a change in margin debt indicating an opposing future stock market move)? To investigate, we compare the behavior of NYSE end-of-month margin debt with the monthly behavior of the S&P 500 index over the period January 1980 through August 2008. Based on experience with other investor sentiment measures, our hypotheses are that: (1) the stock market and margin debt move up and down together; and, (2) changes in margin debt do not reliably predict changes in the stock market. We find that...

The following chart compares the end-of-month values of the S&P 500 index and NYSE margin debt for January 1980 through August 2008, scaled for comparability. It shows that the stock market and margin debt track closely. When the stock market is high (low), margin debt is very likely to be high (low). This result supports hypothesis (1) above.

Might the ratio of these two variables be informative?

The next chart plots the ratio of end-of-month NYSE margin debt in billions of dollars to the end-of-month S&P 500 index from January 1980 through August 2008. Over this period, the ratio appears to be mostly growing rather than mean-reverting, with pronounced growth during the 2000s. In other words, leverage has accounted for more and more of total market capitalization over this period. There may be some tendency for the ratio to spike at the onset of bear markets, but the sample is not long enough for reliable inference regarding this observation.

For greater precision, we compare contemporaneous monthly changes in the two series.

The following scatter plot relates the monthly change in the S&P 500 index to the same month change in NYSE margin debt over the entire sample period. If these two variables move together in the short term, as their long-term behaviors suggest, a best-fit line should rise from lower left to upper right on the plot. In fact, the best-fit line does have a positive slope, but the plot shows considerable dispersion. There are two outliers corresponding to a large drop in the stock market in October 1987 and a large jump in margin debt in January 1993.

The Pearson correlation for these series is 0.31 and the R-squared statistic is 0.10 (including the two outliers), indicating that the monthly change in margin debt explains 10% of the same-month movement in the S&P 500 index. This result provides some additional support for hypothesis (1) above. Without the January 1993 outlier, the R-squared statistic is 0.12.

Does either series reliably lead the other?

The next chart shows the correlations between monthly changes in NYSE margin debt and the S&P 500 index assuming various lead-lag relationships between them, both for the entire sample period and for the second half of the sample period. Results suggest that, if either variable leads the other, it is the stock market that leads margin debt by one or two months. When the stock market rises (falls), there is some tendency for margin debt to rise (fall) in the next one or two months. However, a change in margin debt says practically nothing about the behavior of the stock market in future months. In other words, some margin debt appears to chase good returns and flee bad returns. Results are consistent for the entire sample period and the more recent subperiod. These results support hypothesis (2) above.

A factor that could affect the relationship between total equity valuation and margin debt is interest rates. When margin interest rates are low (high), margin debt may be more (less) attractive as leverage. The following chart compares the end-of-month Federal Funds Rate (as a proxy for the margin interest rate) and the ratio of monthly NYSE margin debt to the S&P 500 index. The Pearson correlation between these two series is -0.41, supporting the hypothesis that interest rates rationally affect willingness to use margin. The great moderation in interest rates since 1980 has encouraged the growth of margin debt as a percentage of total equity market capitalization.

One might assume that changes in margin requirements (degree of leverage allowed investors by brokers) could also affect the relationship between the stock market and margin debt. However, the Federal Reserve Bank of San Francisco has concluded that "changes in [margin] requirements do not have a significant permanent effect on the behavior of stock prices".

In summary, margin debt tends to lag the stock market by one or two months. Evidence does not support a belief that monthly changes in margin debt reliably predict future monthly stock market behavior.

For related research, see Blog Synthesis: Sentimental Journey.