Earlier this week my colleague Chris Preston pointed to a recent spike in the number of initial public offerings.
Chris drew a parallel to the large number of internet company IPOs leading up to the collapse of dot-com bubble. Is this a sign that a stock market bubble is brewing?
Chris noted that the IPO-day price surges aren’t nearly as frenzied as they were during that period. “While the number of new IPOs is staggering, investor response to those IPOs isn’t nearly as out of whack as it was during the dot-com boom.”
But Chris notes that we’ll need to keep a close watch on the IPO market as a sign of a bubble.
Indeed, many of us here at Wyatt Investment Research have been paying close attention to the market in recent months for early signs of a stock market bubble.
Just yesterday I noticed another potential warning sign. The chart below illustrates my concerns.
The chart shows the S&P 500 compared to margin debt, the volume of stocks purchased by investors using borrowed money. It last topped out in 2007 shortly before the financial crisis began, causing many to wonder if its current high levels are cause for concern.
Why might margin debt be so concerning?
Margin investors are required to maintain a certain amount of collateral to back up their margin loans. As the market begins to fall, investors can find themselves having to sell other assets in order to maintain enough collateral.
Making matters worse, collateral requirements are often raised in times of market volatility. This is to protect the companies loaning the money from losing it all if the investors are wiped out. But it can also make matters worse, as investors have to sell even more of their positions in order to meet higher collateral requirements.
What this creates is a situation in which margin investors are forced to sell their investments even as they are falling in value. The indiscriminate selling can make the market fall even faster, leading to stock market crashes.
If you look at the chart above you can see clear visual evidence of this.
In late 2008 as the markets were collapsing you can see the amount of margin debt collapsing even faster.
Investors are again increasing their leverage to increase their gains while risking the compounded losses that could occur if the market turns against them.
According to bond expert Jeffrey Gundlach, margin debt is back in the “scary zone.”
However it is unclear to him and other experts whether margin debt is a cause or an effect of the rising market. On the flip side, it is unclear whether margin debt would be a cause or an effect of a market crash.
Thus, it is tough to tell whether rising margin debt used to purchase NYSE stocks is proof of a stock market bubble. But I know I’d be more comfortable with the current market levels if that margin debt metric was lower.
Regardless, this metric is something that investors should watch closely. I’m of the mind that historically high levels of margin debt could trigger a major market event out of an otherwise normal market pullback.
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