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Margin Debt Approaching Record Highs

(December 21, 2006)

Dear Subscribers and Readers,

Despite the fact that the consensus among Bloomberg and Businessweek forecasters is for a positive year in 2007, it is definitely notable that both the average and the median predictions are calling for a market to be mildly bullish next year – that is, positive but below average.  Combined with the ISE Sentiment, the AAII survey, mutual fund inflows, etc., this does not signal extreme bullishness to me and therefore is not indicative of a significant top just yet.  That being said, there are now significant headwinds for the U.S. stock market in the short-run.  These headwinds may even be strong enough for us to shift the 100% long position in our DJIA Timing System to a 50% long position (I will elaborate on our short-term strategy towards the end of this commentary).  Without further ado…

I want to begin our commentary with a quote from the fictional biography of Jesse Livermore “Reminiscences of a Stock Operator” by Edwin Lafaevre.  This is effectively Jesse Livermore himself speaking – right before the break that ultimately became known as the “Panic of 1907”: “But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities. In short, I had learned that I had to work for my money. I was no longer betting blindly or concerned with mastering the technique of the game, but with earning my successes by hard study and clear thinking. I also had found out that nobody was immune from the danger of making sucker plays. And for a sucker play a man gets sucker pay; for the paymaster is on the job and never loses the pay envelope that is coming to you.

Okay, I admit.  After arriving in Houston last Thursday evening to spend Christmas and New Year's with my family and friends, I had not been watching the stock market or the screen as closely as I usually have.  The end result?  Weakness in the stock market that I should have foreseen or at least anticipated – but just like Livermore said, the paymaster is always on the job and for a sucker play (in this case, I did not spend enough time on the market so I guess you could rephrase that as “lousy effort”) you get sucker pay.  When a trader goes on vacation, the ideal scenario is for him or her to liquidate all holdings prior to the vacation, but since I have many investors of all walks of life to cater to, I obviously will need to keep track of the stock market whenever I can.  After all, I can't tell our subscribers to sell all their holdings prior to MY going on vacation, can I?

Let us first discuss “red flag number one.”  Assuming that margin debt outstanding for NASD members are unchanged for the month of November (data for NASD margin debt is not usually released until over a month later – which is usually not important as NASD margin debt makes up less than 10% of overall margin debt), total margin debt (as measured by the amount of NYSE and NASD margin debt outstanding) increased from $267.7 billion at the end of October to $293.9 billion at the end of November 2006.  Total margin debt is now a mere $6.0 billion away from the all-time high of $299.9 billion reached in March 2000.   Under normal circumstances, this is usually not a problem, as the amount of margin debt has historically hit higher highs during successive cyclical bull markets – even during the cyclical bull markets within the secular bear market of 1966 to 1974 (see below chart):

Margin Debt (January 1966 to December 1974)

So Henry, why do you say the latest margin debt number is a “red flag?”  My concern is the rate of ascent in the latest amount of margin debt outstanding.  During November, total margin debt (again, assuming a net change of zero for NASD margin debt outstanding) increased $26.2 billion – which, as subscribers may not know, represented a record, surpassing the monthly increase in margin debt during the months of November 1999, December 1999, and February 2000.  Following is monthly chart showing the Wilshire 5000 vs. the 3, 6, and 12-month changes in margin debt from January 1998 to November 2006:

Wilshire 5000 vs. Change in Margin Debt (January 1998 to November 2006) - As shown on this chart, the rate of increase in margin debt experienced the greatest one-month spike since February 2000. Note that while the 12-month change in margin debt is now at its highest since September 2005, the 3-month and the 6-month changes are even more extreme, as the former is now at its highest since March 2000 and the latter since May 2000!

As mentioned on the above chart, the 12-month change in margin debt ($51.0 billion) is now at its highest since September 2005 due to the latest one-month spike in margin debt.  More importantly (and even more extreme), the 3-month and the 6-month increases in margin debt is now at its highest since March 2000, and May 2000, respectively!  Let there be no mistake: Given the immense leverage in the U.S. stock market at this time, this author will definitely not be initiating long positions anytime soon – as the market is now very vulnerable to a significant sell-off.

No matter how much leverage there is, the U.S. stock market can continue to do well if demand for U.S. shares remains robust.  That being said, however, there are now signs that demand has been and is continuing to weaken.  One sign of weakening demand usually comes in the form of divergences – and the most flagrant divergence today (at least in Dow Theory terms) is the most recent divergence of the Dow Transports vs. the Dow Industrials.  Following is the most recent daily chart showing the Dow Industrials vs. the Dow Transports from October 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to December 20, 2006) - 1) Very ominously, the Dow Transports has continued to diverge from the Dow Industrials over the first three days of this week, as the Dow Transports declined 116.10 points even as the Dow Industrials rose 18.35 points over the last three days. More importantly, the Dow Transports is now below its most recent closing low (made on November 3, 2006) of 4,612.69, as the Dow Transports closed at 4,584.91 on Wednesday afternoon. 2) After over six years, the Dow Industrials has finally surpassed its all-time high (on October 3, 2006) of 11,722.98 made on January 14, 2000, while the Dow Transports surpassed its all-time high of 3,783.50 (made on May 12, 1999) way back in December 2004.

As mentioned on the above chart, the Dow Transports has already declined 116.10 points over the last three days of trading.  More ominously, the Dow Transports also closed below its most recent closing low of 4,612.69 made on November 3, 2006.  Unless the Dow Transports has a very strong rally over the next two days (Thursday and Friday), there is a good chance that we will pare back our 100% long position in our DJIA Timing System to a 50% long position.

Red Flag Number 3: Lack of Retail Traffic?

Over the last five days, this author has been to (and spent several hours in each) three different malls in the Houston area – and the lack of foot traffic in all these malls have surprised me.  Since Christmas this year will fall on a Monday, there is a good chance that many folks are relying on this weekend to do most of their Christmas shopping.  Other factors that could account for the lack of retail traffic include: 1) The trends towards heavier use of gift cards, suggesting that many gift givers no longer need to spend significant time at the mall, and 2) The prevalence of online shopping.  While retail traffic may not be high this year, online shopping has been increasing at a significant rate over the last few years.

As I am reading up on retail news, it looks like many retailers are expecting the upcoming weekend to be a “close to blowout” weekend.  However, this author is not taking any chances, given the lack of retail foot traffic I have observed over the last five days, the sizable discounts (New York & Company was running a 50% discount on all store items), and given the weakness in the Retail HOLDRs (RTH) over the last four trading days, as shown on the following chart courtesy of

RTH (Retail Holders)

I will again be going to a different mall (Katy Mills west of Houston on I-10) tomorrow (Thursday) in order to do more observations and to do some “last minute” shopping myself.  Should the RTH fail to bounce strongly over the next couple of days, and should I continue to observe mediocre traffic tomorrow, there is a good chance I will pare back our 100% long position in our DJIA Timing System to a 50% long.  At this point, anything that is not “close to blowout” during this upcoming weekend for retailers will be a disappointment, and given the short-term overbought condition in the stock market, as well as the huge increase in leverage during November, I am not going to take any chances here.

In conclusion, I would like to apologize to those who are not actively watching the markets or their positions at this time of the year.  But as Jesse Livermore said over 80 years ago – if you have existing (trading) positions in the stock or the commodity markets – you should watch them like a hawk.  The market does not care whether it is Memorial Day, Thanksgiving, or Christmas.  I do not like switching our stance during the Holidays, but should the market continue to exhibit weakness in the days leading up to this weekend, there is a good chance we will shift our 100% long position in our DJIA Timing System to a 50% long position (most likely, I will make this transition/transaction if we see a bounce in the stock market but with weak breadth and/or volume).

Signing off,

Henry To, CFA

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