Margin debt, the amount of money people have borrowed to buy stocks, is not only at a record high – it's accelerating.
This margin debt level is another sign that a stock market crash, while not necessarily imminent, is becoming more and more likely.
According to New York Stock Exchange data, margin debt reached $451.3 billion at the end of January – the fifth record month in a row.
The higher the margin debt goes, the more likely a stock market crash, or at least a sharp correction, becomes.
"As that debt goes up, the market's foundation gets shakier and shakier," Brad McMillan, chief investment officer for Commonwealth Financial, told MarketWatch.
What's especially ominous about this is that the last two severe market crashes, the dot-com bust of 2000 and the financial crisis of 2007-2008, were both preceded by sharp spikes in margin debt.
Take a look at the chart. It shows the percentage gain of the Standard & Poor's 500 index and margin debt since 1995, adjusted for inflation.
Note the steep rises in margin debt in 1999 and 2006-2007. Each peak was followed a few months later by a major stock market crash.
Margin debt as a percentage of gross domestic product (GDP) is also soaring. At the end of January, it hit 2.64%, higher than the 2.62% it reached in July 2007 and approaching the 2.78% it hit in March of 2000.
And while it's true that the U.S. Federal Reserve's historically low interest rates have played a big role in raising the levels of margin debt by providing a lot of cheap money, it can't totally explain away the recent acceleration in borrowing.
"Margin debt is now at levels higher than when the financial crisis began and volume is declining at the same time the markets have chipped up," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "This suggests that people are leveraging themselves to the hilt in an attempt to pursue returns rather than chasing actual results, as is the case in early bull market rallies."
And spiking margin debt is not the only market indicator signaling that a top may be near.
High Margin Debt Just One of Several Red Flags
Both the Dow Jones Industrial Average and the S&P 500 are trading close to their record highs. The current bull market just celebrated its fifth birthday, which makes it the sixth-longest in history. The average bull market runs just 4.5 years; only three bull markets out of 11 since 1945 have made it to a sixth year.
Valuations are also getting toppy. The average price-to-earnings ratio is getting close to 18, which is about where most bull markets surrender.
Fitz-Gerald said he's also worried that stock prices are getting out of whack with earnings.
"The markets have run 30% to 40% higher while earnings haven't budged," Fitz-Gerald said. "Usually, earnings drive prices, so this is a reversal in that prices are now 'pulling' earnings. This, too, is a sign that the rally may be growing tired."
While no one can predict exactly when a market will turn south, these trends should have every investor on high alert for the next correction – or stock market crash.
Protect Yourself from a Stock Market Crash
When stock market downturns happen, as they always do, investors don't have to lose their shirt.
Fitz-Gerald said investors can take several steps to minimize the damage when a stock market crash strikes. And note that panic selling is not on the list. Here's what you can do:
About the Author
Dave has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.
Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.
Dave has a BA in English and Mass Communications from Loyola University Maryland.