Margin Debt Has Soared. It’s the Skunk at Wall Street’s Garden Party.

Market declines can become steeper as margin debt rises. (Timothy A. Clary / AFP / Getty Images)

Key Points

About This Summary

• Margin debt has increased 69% from its 2022 low, reaching $1.1 trillion, nearing the 2021 record, amplifying both gains and losses.
• Margin debt is 1.9% of an S&P 500 worth $56 trillion.
• Analysts caution that a single-digit S&P 500 drop could push margin debt above 2%, potentially triggering more selling and market declines.

The dollars that investors borrow to buy stocks has jumped, a risk to the market.

With what’s commonly called margin debt, an investor buys $100 worth of stock by borrowing $50 from the broker, for example.

Only $50 is the investor’s initial equity investment. If the stock price climbs to $120, the investor’s return is 40% because the $20 of profit came on $50 of investment. So margin debt amplifies returns.

It works the same way with losses. If that $100 worth of stock drops to $80, the loss is 40% on the $50 of investment.

Neither the government nor brokerages allow losses to become too large. The rule of the Financial Industry Regulatory Authority (Finra) is that equity in margin accounts can’t drop below 25% of the value of the holdings.

If a stock price falls enough that the margin account falls below 25%, the investor must deposit more cash into the account to abide by FINRA’s threshold. To do that, the investor usually has to sell shares to raise enough cash.

That’s why market declines can become steeper as margin debt rises. Investors rush to sell the minute the value of their stocks falls too close to Finra’s 25% threshold.

Margin debt, according to Finra, stands at $1.1 trillion—up 69% from the 2022 low of roughly $650 billion and nearing the record high of almost $1.2 trillion set in 2021. Every time the value of the market jumps, investors can borrow more because each borrowed dollar represents a lower percentage of the value of stocks. Consequently, their margin accounts aren’t out of control and their debt balances balloon.

That’s why it’s important to note that debt dollars, despite their increase, aren’t so high compared to the size of the market. Margin debt is still only 1.9% of an S&P 500 worth $56 trillion, according to FactSet. That’s down from a high for this century of almost 3.5%, according to research firm First Trust Economics.

The concern is that risk is slowly building. Margin debt as a percentage of the S&P 500 hit a multidecade low of 1.6% last year and has begun to creep higher to its current level.

“This latest jump warrants caution,” write analysts at First Trust Economics.

To that point, it takes a mere single-digit percentage drop in the S&P 500 to bring margin debt to above 2% of the index. After any brief dip, some traders will see the equity values of their accounts drop too low, forcing more selling—and more market declines.

Consistent with that, surging debt dollars tend to cause more-than-minor market declines. Margin debt balances hit record highs in 2000, 2007, and 2021, according to ICAP Technical Analysis. The S&P 500 drops that came months after those points were all greater than 20%.

That type of drop doesn’t have to happen today. But the point is that the market is vulnerable to some sort of fall, with a faint possibility of a worse-than-20% drawdown. Margin debt is close to a record and becoming a large portion of traders’ accounts.

A selloff won’t begin until an economic catalyst emerges. On Thursday, the three major indexes were in the green, dancing with abandon to the Federal Reserve’s first rate cut this year and the hope that the central bank will cut more to keep the economy growing.

That won’t happen, though, if inflation remains above the Fed’s 2% annual target for long enough. Fewer—or no—additional cuts would pressure the market.

Another scenario would be economic data that fails to meet expectations before lower rates boost the economy. That could also hurt the market.

If a catalyst emerges, the selling could become exaggerated because of the extraordinary amount of margin debt.

It’s a sticky wicket, to be sure. But this is for sure: Risk to the market is becoming more pronounced, and buying more stock today just isn’t the best idea.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com