In the stock market, rising leverage fuels buying pressure; declining leverage fuels selling pressure.
By Wolf Richter for WOLF STREET.
Margin debt as reported by FINRA, based on data submitted by its member brokers about their clients’ margin loans, is the only measure of market leverage that we have. FINRA reports it monthly. There are many other forms of market leverage – including those that felled Archegos and saddled banks with huge losses – but those forms of leverage are not tracked on a market-wide basis. Margin debt is a stand-in to indicate broader trends.
Margin debt fell by $38 billion in July, from the historic high in June, the first drop since March 2020, according to FINRA today. For the 15 months through June, stock market leverage overall had been on a mind-boggling rampage, with margin debt alone soaring by 84%. This surge in leverage fueled buying pressure funded with borrowed money. And in July, after those 15 months, margin debt dropped:
Markets piling on leverage is the expected result of the Fed’s policies of interest rate repression and asset purchases, which is inflating asset prices, as investors back up the truck and load up and borrow on margin to load up further, which drives prices up further.
Leverage creates buying pressure and drives up prices – and thereby increases collateral values in brokerage accounts that then can be leveraged up further to drive up prices further. It’s the great accelerator on the way up.
It also drives up risks – as Archegos and its prime brokers figured out when it blew up. When nervous investors deleverage, they sell assets and use the proceeds to pay down their margin debt. Longer periods of dropping margin debt are associated with big stock market sell-offs.
July was just the first drop in margin debt after a 15-month spike – and maybe it was just a go-on-vacation summer lull, or maybe it was the first step of a persistent decline.
As with any dollar-denominated chart that spans two decades, it’s not the absolute level that is important because the purchasing power of the dollar has declined.
What’s important are the systematic moves: The big jumps in margin debt spanning many months that are associated with big rallies in the stock market; and the big multi-months drops in margin debt that are associated with big drops or crashes in the stock market. Margin debt and stock market levels are linked because rising leverage fuels buying pressure, and declining leverage does the opposite and fuels selling pressure.
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