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Warning: This Year’s Spike in Margin Debt Is a Huge Red Flag for the Market

This is a syndicated repost courtesy of Money Morning. To view original, click here. Reposted with permission.

Margin debt, the amount of money people have borrowed to buy stocks, is not only at a record high – it’s accelerating.

This margin debt level is another sign that a stock market crash, while not necessarily imminent, is becoming more and more likely.

According to New York Stock Exchange data, margin debt reached $451.3 billion at the end of January – the fifth record month in a row.

The higher the margin debt goes, the more likely a stock market crash, or at least a sharp correction, becomes.

“As that debt goes up, the market’s foundation gets shakier and shakier,” Brad McMillan, chief investment officer for Commonwealth Financial, told MarketWatch.

record margin debtWhat’s especially ominous about this is that the last two severe market crashes, the dot-com bust of 2000 and the financial crisis of 2007-2008, were both preceded by sharp spikes in margin debt.

Take a look at the chart. It shows the percentage gain of the Standard & Poor’s 500 index and margin debt since 1995, adjusted for inflation.

Note the steep rises in margin debt in 1999 and 2006-2007. Each peak was followed a few months later by a major stock market crash.

Margin debt as a percentage of gross domestic product (GDP) is also soaring. At the end of January, it hit 2.64%, higher than the 2.62% it reached in July 2007 and approaching the 2.78% it hit in March of 2000.

And while it’s true that the U.S. Federal Reserve‘s historically low interest rates have played a big role in raising the levels of margin debt by providing a lot of cheap money, it can’t totally explain away the recent acceleration in borrowing.

“Margin debt is now at levels higher than when the financial crisis began and volume is declining at the same time the markets have chipped up,” said Money Morning Chief Investment Strategist Keith Fitz-Gerald. “This suggests that people are leveraging themselves to the hilt in an attempt to pursue returns rather than chasing actual results, as is the case in early bull market rallies.”

And spiking margin debt is not the only market indicator signaling that a top may be near.

High Margin Debt Just One of Several Red Flags

Both the Dow Jones Industrial Average and the S&P 500 are trading close to their record highs. The current bull market just celebrated its fifth birthday, which makes it the sixth-longest in history. The average bull market runs just 4.5 years; only three bull markets out of 11 since 1945 have made it to a sixth year.

Valuations are also getting toppy. The average price-to-earnings ratio is getting close to 18, which is about where most bull markets surrender.

Fitz-Gerald said he’s also worried that stock prices are getting out of whack with earnings.

“The markets have run 30% to 40% higher while earnings haven’t budged,” Fitz-Gerald said. “Usually, earnings drive prices, so this is a reversal in that prices are now ‘pulling’ earnings. This, too, is a sign that the rally may be growing tired.”

While no one can predict exactly when a market will turn south, these trends should have every investor on high alert for the next correction – or stock market crash.

Protect Yourself from a Stock Market Crash

When stock market downturns happen, as they always do, investors don’t have to lose their shirt.

Fitz-Gerald said investors can take several steps to minimize the damage when a stock market crash strikes. And note that panic selling is not on the list. Here’s what you can do:

  • Use Protective Stops: At Money Morning, the use of protective stops is a mantra. That’s a standing order with your broker to sell a stock that you own either at a set price, or after a set percentage decline (25%, for example). That ensures you retain profits on positions where you had large gains, and in general preserves your capital.
  • Buy Gold: If the markets head south, gold will rise rapidly. And given that the yellow metal is off 30% from its highs of 2011, now is a great time to buy gold. Fitz-Gerald recommends the SPDR Gold Shares ETF (NYSE Arca: GLD): “It’s liquid, easily tradable, and cost efficient.”
  • Buy an Inverse Fund: Fitz-Gerald says investors should put about 3% to 5% of their portfolios in an inverse fund, such as the Rydex Inverse S&P 500 Strategy Fund (MUTF: RYURX) or an inverse ETF like the ProShares Short S&P500 (NYSE Arca: SH). “These things go up when the markets go down, and down when the markets go up. So they’re very cheap at the moment. But they won’t be when the train leaves the station.”
  • Keep Your Pencil Sharpened: Bear markets create bargains. Investors should make a list of quality stocks they’d like to own, and then wait for the prices to drop. While the bear is rumbling, average into your position over a period of weeks or months. “Discipline never goes out of style,” Fitz-Gerald said. “Your best friend right now is a carefully thought out, pre-planned investment program that helps you eliminate the kinds of knee-jerk reactions that will skin most investors for the third time in a decade – once on the way down, once because they buy in at the wrong time or with too much money, and once because they get left on the sidelines when things eventually sort themselves out.”

Are you worried that the spiking margin debt is a sign that a stock market crash is getting closer? And do you have a plan to deal with it? Talk about it on Twitter @moneymorning or Facebook.

It has been more than two years since we had a stock market correction, which is yet another reason why the next drop could very well turn into a stock market crash. Here are the 10 biggest one-day plunges in the history of the Dow…

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The post Warning: This Year’s Spike in Margin Debt Is a Huge Red Flag for the Market appeared first on Money Morning – Only the News You Can Profit From.

Wall Street Examiner Disclosure: Lee Adler, The Wall Street Examiner reposts third party content with the permission of the publisher. The opinions expressed in these reposts are not those of the Wall Street Examiner or Lee Adler, unless authored by me, under my byline. I curate posts here on the basis of whether they represent an interesting and logical point of view, that may or may not agree with my own views. Some of the content includes the original publisher's promotional messages. No endorsement of such content is either expressed or implied by posting the content. All items published here are matters of information and opinion, and are neither intended as, nor should you construe it as, individual investment advice. Do your own due diligence when considering the offerings of information providers, or considering any investment.

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