This chart is a ticking time bomb for stocks

The last six years for the U.S. stock market have been an indomitable buying orgy fueled by the Federal Reserve’s zero interest rate policy, causing the S&P 500 to triple in value. One metric says it may have gone too far.

Borrowing to buy stocks, as measured by the NYSE monthly margin debt figures, ended 2014 at its highest level relative to the size of the U.S. economy since 1929. In absolute terms, it’s the highest ever.

“If this doesn’t count, then we might as well throw away everything we’ve ever learned about risk because there is none,” said Alan Newman, who sent this data to customers of his Crosscurrents newsletter last week. “The manias of 2000 and 2007 now both look like small potatoes by comparison. This is total insanity.”

As noted on Newman’s in chart, buying stocks on margin peaked in 2007 before the popping of the housing market bubble, as well as in March 2000, exactly when the Nasdaq Composite’s frenzied tech boost ended, causing share prices to be cut in half.

While too often ignored by the masses, this indicator has a storied history among long-time market data crunchers. It was, after all, buying stocks on margin that was the single cause of the infamous crash of 1929.

But like any single indicator, its track record isn’t perfect. Elevated buying on margin can go on for long period of times before it has consequences, history shows. And stock borrowing itself is not a bad thing. In fact, signs of a pickup can mark the start of a healthy bull market. And some of this elevated borrowing can be due to risk arbitrage related to M&A.

Even Newman admits this is not a call to sell all stocks tomorrow, but that doesn’t mean it should be ignored.

At the very least, traders said, elevated buying on margin could make 2015 a bumpier ride than the last few years because it can exaggerate the market’s moves to the downside. As stocks fall, margin calls beget more selling and so on.

“This chart on margin debt suggests that the ‘cash on the sidelines’ them has run its course,” said Steve Cortes of Veracruz TJM. “In fact, with both margin debt and total market cap at nose-bleed highs relative to GDP, it seems that equity prices are at least fully valued, if not dangerously flirting with bubble-like prices.”

 Varchev Traders

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