Margin trading and wealth creation By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

November 25, 2015 | Posted by bobbysrinivasan << back to blog

The US stock market index S and P 500 climbed 204% from March 2009 through December 2014, an astonishing performance. But since the beginning of this year the market has lost its steam and hence the growth in the index remains flat. The contributor to the major growth in the index is the margin debt (margin debt is the value of stocks with borrowed money). In the last 20 years the level of margin of debt had increased 500%. The risk involved in speculating became minimal. Since zero interest meant plenty of liquidity. Great appetite for risk, acceptable very high P.E. have all contributed to this bull run. The Dow Jones is trading around 17000 and the S and P 500 around 2100. Has it peaked yet? When is the correction expected? is the conversation between the student and his professor.

Student: I have always been taught by my ultra conservative professors that margin trading is risky. You are now telling me that investors have made fortunes.

Professor: First, understand the risk is part of any investment. You cannot avoid it, but can manage it. I will give you examples. Margin of debt growth accelerated in the late 1990’s. It peaked in March 2000 the same month S and P topped out. The US stock market went onto loose 37% during the dot.com bubble burst. Margin of debt growth accelerated in the 2000’s. It peaked in July 2007, just three months before S and P topped out before the financial crisis. Stock went on to decline 57%. Similarly margin debt had a small run-up in 2011 before turning over that May. The S and P peaked right around the same time. Then it declined 19.4%.

Student: Are you then suggesting that the current market is in a bubble and is about to burst?

Professor: I am not saying that but whenever the debt level peaks out, the market is set for major corrections. We are hearing about the Fed thinking of pushing up the Fed funds rate in December. When the hike takes place it is more likely to happen several times as people rush to larger loans before the interest rate goes even higher. Currently the margin of debt for the NYSE is at an all-time high of $ 507 billion. When and if this contracts we will have a major correction. Currently the corporate earnings are flat and will continue to be so because the economic growth is slowing down. The smart money is already moving out but the trend is not yet set.

Student: How will it affect our market?

Professor: I don’t know the size of margin trading here. But every time the US makes a major correction, the Indian Sensex follows suit. For example, in 2009 the Sensex dropped from 21000 to 8000 during the US sub-prime crisis.

Student: Professor, I understand globalisation well. Thank you.

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