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The Biggest Threat to Your Portfolio

While the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and the S&P 500 (SNPINDEX: ^GSPC  ) hit record highs this week, there are troubling signs that the market's rally is unsustainable. Investors are using leverage to boost returns, and leverage is hitting record highs. Previous bubbles have been shown to be heavily inflated by investors who are buying stocks with margin debt, and this time is no different. What's going on, and what can you do to protect yourself?

What is margin debt?
Margin debt refers to a loan you take from your broker to buy stock. With the Federal Reserve keeping rates at all-time lows, margin debt is cheaper than ever.

Loan Balance



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The dangers of leverage
Over the years, numerous investors have sounded the alarm over investing with borrowed money. Most famously, Warren Buffett has said:

I've seen more people fail because of liquor and leverage -- leverage being borrowed money. You really don't need leverage in this world much. If you're smart, you're going to make a lot of money without borrowing.

A great example of the perils of investing with margin debt comes from the former third member of Warren Buffett's trio of investors. Rick Guerin decided he wanted to get rich quick and used leverage to boost his returns. In the bear market of 1973-1974, when the market dropped 70%, Guerin got tons of margin calls and was forced to sell his Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) shares to pay off the loans. The rest is history, as Warren Buffett and Charlie Munger went on to make Berkshire the powerhouse it is today.

A dangerously inflating bubble
While Federal Reserve Chairman Ben Bernanke said just last week that "I don't see much evidence of an equity bubble," I believe the signs of a bubble are growing. At the end of every month, the New York Stock Exchange reports the previous month's value of margin loans investors hold, as well as cash and credit in those accounts. We have to wait till the end of the month for February's numbers, but we can see that in January, margin debt climbed to near the all-time highs set in the previous bubble.

Sources: Facts & Figures, St. Louis Federal Reserve.

Perhaps more ominous, the difference between credit and margin debt in accounts is expanding to near the all time high of -$213 billion that was hit during the Internet bubble.

Sources: Facts & Figures, St. Louis Federal Reserve.

Sources: Facts & Figures, St. Louis Federal Reserve.

The New York Stock Exchange only began collecting data on cash in margin accounts starting in 2003, but you can still see the net value of investors' margin accounts. The free credit line is inverted so that when the red line is up, that means investors are net in debt, and when the red line is way down, that means investors have more credit and cash in their accounts than debt. In January, investors had nearly $77 billion more debt in their accounts than they had investments and cash.

Sources: Facts & Figures, St. Louis Federal Reserve.

Foolish bottom line
All these charts show that investors are using leverage at levels not seen since the last bubble to juice their returns. This has ended badly in every previous bubble, and it will end badly again.

Trying to time the bursting of a bubble is a fool's errand. It's impossible to get the timing right. I suggest sticking with your investment plan but keeping some cash on the side to buy in case the market takes a big drop. As Thomas Edison said, "Everything comes to him who hustles while he waits." Take time to carefully research investments and keep a watchlist of companies you'd like to buy at the right price.

If you're looking for some long-term investing ideas, you're invited to check out The Motley Fool's brand-new special report, "The 3 Dow Stocks Dividend Investors Need." It's absolutely free, so simply click here now and get your copy today.

Read/Post Comments (3) | Recommend This Article (19)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 16, 2013, at 1:27 PM, yourbestfriend wrote:

    this article's method of indicating "danger" is to look for high absolute margin debt levels.

    but it might as well be looking for high absolute dow and s&p levels.

    because those coincide with peaks followed by crashes in the dow and s&p, too.

    it's numerical voodoo, begging the question, post hoc ergo propter hoc, and a presumption that past results dictate future performance.

    do it again, but instead look at the percentage of invested money that is collateralized on margin, and include all sources of investment, not just equities. the last crash didn't happen because of high stock-market equity margin, it happened because of stunningly astronomical margin on Nth-order real-estate derivatives. so do it again, and do it right this time. it's an interesting question that should be answered in the financial news alongside the question of what the dow's level is every day.

  • Report this Comment On March 18, 2013, at 12:23 AM, Apacheman15 wrote:

    I think the best indications that we are not near an equity bubble ibursting is this.... The Feds easy money policy has made it next to impossible to earn a decent return in anything except equities. By historical measures, the average stock P/E is about average to slightly below average. Corporations have record amounts of cash that they are giving back to shareholders either through dividends or share buybacks. Both of these givebacks make owning stock more attractive. Although the Dow Jones has finally reached its all time high, it is still nowhere near the P/E valuation that it reached when the last bubble burst.

  • Report this Comment On March 25, 2013, at 1:39 AM, whyaduck1128 wrote:

    "While Federal Reserve Chairman Ben Bernanke said just last week"

    The more Ben Bernanke speaks, the more I believe that he doesn't know diddly. If Ben Bernanke says the sun rises in the east, I'm going to get up before dawn to verify it rather than take his word for it.

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