Margin debt on the NYSE can be a useful indicator of how Mr. Market is feeling. If optimism is high, people tend to borrow more to buy stocks. Previously, we’ve seen how margin debt through the last recession fell mightily and did not return to its previous highs for several years. Through last year and the first part of this year, it looked like margin debt would follow a similar path.
In the last six months, however, investor appetite for risk appears to have returned, with margin debt making a small comeback. Here is a look at the use of margin debt on the NYSE through August of 2009:
While margin debt is still well below its 2007 high, it has surprisingly not fallen to the lows seen in 2002. Indeed, margin debt levels are now at 2005 levels and appear poised to continue their ascent: these numbers are through August; as the market rose through September, it is likely that margin debt continued to increase further.
If we look at the ratio of margin debt to the index level of the S&P 500, we see that debt as a percentage of the market remains historically high, at least compared to what it was in the last recession:
The proliferation of hedge funds over the last decade is likely at least partially responsible for this increased willingness to purchase stocks with debt. Nevertheless, investors should take note that a relatively high proportion of the market’s capitalization is currently financed by debt, suggesting that there is a significant amount of downside risk to the market if these debt positions are forced into liquidation.