The market sell-off last week was the worst week for United States stocks since 2011 and put the S&P 500 Index 7.5% below its recent peak on May 21.
The Dow Jones Industrial Average was down 10.1% since the May high. Huge losses were suffered in Europe and Asia, as well.
The recent panic selling in the market tends to feed on itself and turn into more panic. Who knows what level of fear tomorrow will bring?
While “buy and hold” investors who don’t panic and ride out the storm may come out OK, the same cannot be said for investors who have large margin balances in their brokerage accounts.
Many investors who buy on margin have no clue about the risks they are taking. Margin loans let investors buy more shares, which magnify gains in a rising market.
But the opposite is true when the market swings downwards.
When stocks decline, loans magnify losses and investors can get margin calls at any time without notice. The fine print in the standard brokerage customer account agreement provides that a firm can force the sale of securities in an investor’s account to meet a margin call. In other words, the brokerage firm can sell the securities without contacting the investor. What’s more, the investor is not entitled to choose which securities and other assets are to be sold.
Your brokerage firm can also increase its margin requirements at any time and is not required to provide the investor with advance notice. In fact, investors can lose more money than they deposit in a margin account, especially if there is a margin call during a fast declining market such as we experienced last week.
Investors have been loading up on margin debt, so the market sell-off comes at a very dangerous time.
The Wall Street Journal reported that Morgan Stanley, Wells Fargo and other firms were making a huge amount of margin calls on client accounts, selling them out at low levels.
NYSE margin debt in April 2015 rose over $30 billion or 6.5% to $507 billion. NYSE margin debt is now equal to a record 2.87% of U.S. GDP, having passed the previous all-time high of 2.78% set in March 2000, at the top of the largest stock market bubble in world history.
The current margin debt level of $507 billion represents a 193% increase from the financial crisis bottom in February 2009 of $173 billion.
In June, margin debt as a percentage of US gross domestic product hit an all-time high – surpassing the previous record high that was set over fifteen years ago in March 2000.
Indeed, a particularly prescient article from the Financial Times at the end of July noted that the excessive amount of margin debt used by investors was an indication that the six year bull market run in stocks was over.
“The Chinese stock markets have delivered a reminder — perhaps most of all to the leadership in Beijing — that markets bolstered by leverage are built on sand,” reported the FT’s Henny Sender. “There were lots of reasons why the raging bull market in China came to an end but one of the principal ones was the extent of margin financing involved. Unofficial calculations overheard in the corridors of the glass towers of Hong Kong suggest that the number could exceed Rmb5.5tn, or more than twice official estimates.”
The lessons for Chinese investors were the same for those here in North America, she noted. “But perhaps US investors similarly need reminding of this truth. Growth in margin financing is on the rise on the other side of the Pacific as well, amounting to some $505 billion in June.”
Although high margin debt will not trigger an equity market collapse, it could exacerbate the downside move should any external shock trigger a sell-off, especially as the ratio of margin debt to total market capitalization is approaching historical danger levels, Sender reported. Moreover, the negative wealth effect of an abrupt decline in the stock market could tip the US economy into recession.
Investors on margin, beware. The past week was your wake up call. You need to deal with your debt as soon as possible as a declining market can force sales of your stocks at rock bottom prices, magnifying your losses.