News Analysis date published New: 
Wednesday, March 30, 2011 - 07:00
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Thursday, August 15, 2013 - 11:09
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Wednesday, March 30, 2011 - 07:00

Why These Investors Could KILL the Bull Market

Wednesday, March 30, 2011 7:00 AM

Success breeds confidence. When it comes to investing, that's not always a good thing. Some investors see a rising portfolio and start to figure out ways to keep their returns moving higher. The simplest way to magnify returns is to borrow money from a broker and re-invest those funds, a practice known as "investing on margin." Yet, when investors have started to buy more and more stocks on margin, they often set the stage for cascading declines in the stock market as margin calls beget yet more selling. That's why you should be concerned that investing on margin is back in vogue, whether you are doing it yourself or not.

A lesson not learned
On March 9, 2000, the Nasdaq index moved up above 5,000 for the first-time ever as investors put increasing amounts of money into scorching tech stocks. Part of that was fueled by a then-record $275 billion in funds that investors had borrowed from their brokers. Many of these investors were leveraged to the hilt, right up to the maximum allowable borrowing limit of 50% of a portfolio.

That high level of borrowing turned out to be a Sword of Damocles over stocks. The market pulled back below 5,000 on March 13 and hit 4,500 by the end of the month. At that point, investors needed to sell stocks just to raise enough money to pay off margin loans as the margin-to-equity ratio started to move above 50% in many accounts. By April 11, the Nasdaq approached 4,000 as sell orders poured in. By May 10, 2000, the Nasdaq was below 3,400 -- a stunning 30% drop in just two months. For folks investing on margin, actual losses were likely well higher, in some cases approaching 50%.

Apparently, investors have forgotten the lessons of that painful era as margin debt is really starting to take off again, even as the major averages have nearly doubled in the past two years. In just the past six months, margin debt has surged 30%, to a record $349 billion.

If the market keeps rising, that risky margin move will have looked smart. A 10% upward move in the market, magnified by margin, could translate into 20% gains or more. Then again, a downward move could have a far greater impact from margin borrowing. Not only will investors magnify their losses, but those foolhardy enough to borrow up the legally allowable limit would face margin calls. And that could trigger margin calls that beget more selling, which begets more margin calls...

Action to Take -->
Even if you don't bet on margin, you have to count this as another rising risk factor for the stock market. The stocks most likely to be subject to margin calls are growth stocks with high valuations. Margin investors tend to borrow to buy more shares of the riskiest stocks, foolish as that may be. You can get the monthly margin interest data on the website of the Financial Industry Regulatory Authority. The data are published every month. If margin interest levels show another dramatic spike when March data are released in April, you really need to grow concerned.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.