Over the past 16 months, the use of margin debt has spiked dramatically.

That has me worried.

Margin debt is money that individuals and institutions borrow against their stock holdings in order to buy more stocks.

Margin debt works great in roaring bull markets.

It does the opposite when things head south.

The link between the use of margin debt and the stock market is pretty clear.

When margin debt spikes, a stock market decline follows – often in rather epic fashion.

The chart below shows the huge increase in margin debt that has occurred since the bottom of the COVID-19-related stock market crash in March 2020.

It sticks out like a sore thumb.

The chart also shows two smaller spikes in margin debt that happened in 1999 and 2007.

If you know your stock market history, you know that 1999 and 2007 were memorable years.

Memorable for all of the wrong reasons.

There was a rapid increase in margin debt in 1999 and into early 2000.

What followed was a brutal bear market.

From its peak in March 2000, the S&P 500 dropped by 49.1%, not bottoming until 30 months later in the middle of 2002.

Ouch!

I remember it well.

The subsequent margin debt spike occurred in 2007.

Again, this was followed by another painful stock market rout.

From its October 2007 top, the S&P 500 fell 56.8%, not bottoming until 17 months later in March 2009.

That crash didn’t last as long, but it was more severe.

I remember that one even better.

The chart above shows those two margin debt spikes and two instances in which the entire S&P 500 was cut in half.

Now here we are again.

Margin debt has again spiked, and as you can clearly see in the chart above, it is spiking in more extreme fashion.

I suspect you know what probably happens next.

History Suggests the Next Year Is Going to Be a Tough One

You probably noticed something in that chart.

While margin debt has skyrocketed since March 2020, it dropped by 4.3% in July 2021.

I’m surprised that this decline hasn’t received more attention in the media.

When margin debt starts rolling over after a big increase, it’s almost always a bad sign.

With margin debt now appearing to have peaked, there really should be a lot of people running around in the financial media yelling “Fire!”

Historically, one year after a peak in margin debt, the S&P 500 has been down 71% of the time. The market undergoes a median decline of 10.7% each year after margin debt peaks.

That is the median.

When margin debt spikes sharply, like it did recently, the one-year (and multiyear) decline tends to be a lot larger than the 10.7% median…

In fact, big spikes in margin debt tend to be followed by nasty bear markets.

We can look to 1929, 1972, 1987, 2000 and 2007 for evidence of this.

The fact that margin debt declined in July and the stock market has continued higher is quite unusual.

When margin debt rolls over, normally the stock market immediately does the same.

Honestly, I don’t quite know what to make of that. But what I do know is that this is definitely a time to be cautious as an investor.

We need to mentally prepare ourselves for the fact that the stock market ride could soon get bumpy.

I’ve noted in recent months that, on a valuation basis, the stock market in the United States has become stretched.

You can circle back on my thoughts here.

With what is happening with margin debt, speculative excesses in meme stocks and market valuations near historic highs, there are just too many warning signs that the stock market is getting into dangerous territory to ignore them.

In the long run, owning stocks is still going to be rewarding.

In the shorter term, there may be some unpleasantness.

Good investing,

— Jody

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Source: Wealthy Retirement