Ominous Sign as Margin Debt Continues to Rise

The biggest threat to your portfolio is the debt that others are taking on to buy stocks.

Mar 7, 2014 at 4:30PM

While the Dow Jones Industrial Average (DJINDICES:^DJI) and the S&P 500 (SNPINDEX:^GSPC) continue to push upward in 2014, with leverage hitting record highs there are troubling signs that investors are using debt to boost returns. Previous bubbles have been heavily inflated by investors buying stocks with margin debt. This time is no different. Read on to find out what's going on and what you can do to protect yourself.

What is margin debt?
Margin debt is accrued via loans from your broker to buy stock; the loan is called "margin." With the Federal Reserve keeping rates at all-time lows, margin debt is cheaper than ever.

Loan Balance

Interactive Brokers

ETRADE

 Schwab

TD Ameritrade

Fidelity

$10,000

1.59%

8.44%

8.5%

8.75%

8.075%

$100,000

1.09%

6.14%

6.875%

7.25%

6.575%

$500,000

1.09%

4.14%

6.75%

7.00%

3.75%

$1 million

0.59%

3.89%

6.25%

6.25%

3.75%

$3 million+

0.50%

3.89%

6.00%

6.25%

3.75%

Source: onlinebrokerrev.com.

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

Many investors are not heeding this advice. At the end of every month, the New York Stock Exchange reports the previous month's value of margin loans held by investors, as well as cash and credit in those accounts.

In the chart below you can see the net credit balance in investors' accounts. The credit balance line is inverted so when the red line is up that means investors are net in debt, and when the red line is down it that means investors have more credit and cash in their accounts than debt. In January, investors had nearly $160 billion more debt in their accounts than investments and cash.

G

Source: NYSE, FINRA, St. Louis Federal Reserve.

We have to wait until the end of the month for February's numbers, but we can see that in January margin debt as a percentage of the economy rose to near the highs that were hit in the last two bubbles.

G

Source: NYSE, FINRA, St. Louis Federal Reserve.

In January, margin debt as a percentage of the economy hit 2.64%. The last time it was this high was in July 2007, at the end of the housing bubble, when margin debt as a percentage of GDP hit 2.62%. The market fell 39% over the next two years. The previous high was in March 2000, during the tech bubble, when margin debt as a percentage of GDP hit a high of 2.78%. The market fell 25% over the next two years.

These charts show investors are using leverage at levels not seen since the last bubble to juice their returns. This has ended badly every time and will end badly again.

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Dan Dzombak can be found on Twitter @DanDzombak or on his Facebook page, DanDzombak. He's extraordinarily optimistic about the future, just not optimistic about real returns given current asset prices. He has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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