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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 1990 through February 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 1990 through February 2008. It shows that the stock market and margin debt track closely. The Pearson correlation for these two series is a very high 0.94. When the stock market is high (low), margin debt is very likely to be high (low). This result supports hypothesis (1) above.
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 monthly change in NYSE margin debt for the same month. If these two variables move together in the short term, as their long-term behaviors suggest, a best-fit line should fall 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 is one outlier not shown on the chart.) The Pearson correlation for these series is 0.31 and the R-squared statistic is 0.10 (both statistics including the outlier), 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.
Does either series reliably lead the other?
The following table shows the correlations between monthly changes in the two variables assuming one leads the other by 0, 1, 2, 3, 4, 5 and 6 months. Results suggest that, if either variable leads the other, it is the stock market that leads margin debt. When the stock market rises (falls), there is some tendency for margin debt to rise (fall) in the next month or so. However, a change in margin debt says practically nothing about the behavior of the stock market over the next few months. In other words, some margin debt appears to chase good returns and flee bad returns. These results support hypothesis (2) above.
A factor that could affect the relationship between the stock market and margin debt is interest rates. When margin interest rates are low (high), margin debt is more (less) attractive as leverage. The following chart compares 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 (a dummy variable intended to indicate relative variation in margin debt over time). The Pearson correlation between these two series is -.25, offering modest but inconsistent support for the assumption that interest rates affect willingness to use margin.
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 short-term or intermediate-term stock market behavior.
For related research, see Blog Synthesis: Sentimental Journey.
