Really nasty market sell offs are notoriously hard to predict. But one factor that can propel a healthy sell off into a nasty sell off is margin debt. When investors become especially bullish they like to increase the size of their bets by borrowing money from their broker and using the stock they’re buying as collateral. This has the effect of magnifying the gains and the losses. When those bets go sour, investors have to raise cash to meet margin requirements (i.e. you have to post a certain level of cash or securities in proportion to what you borrowed) – if they’re already over extended and using borrowed money to buy stocks then they have to sell their stock in order to raise that cash. This is known as forced selling and it is something you never, ever want to do.
The SEC actually has a nice little summary of how margin works and highlights the following risks:
- You can lose more money than you have invested;
- You may have to deposit additional cash or securities in your account on short notice to cover market losses;
- You may be forced to sell some or all of your securities when falling stock prices reduce the value of your securities; and
- Your brokerage firm may sell some or all of your securities without consulting you to pay off the loan it made to you.
A recent NYT article highlights the margin debt “danger zone” at 2.25% of GDP. According to their research, when that threshold is breached, bad things generally happen – see charts below.
Between high corporate profit margins, the threat of QE being dialed back, and high levels of margin debt – it seems the seeds for a considerable market correction have been sewn. Buyer beware.