Will margin debt cause the next stock market crash?

The latest fear on Wall Street is that record levels of margin debt may end up toppling the stock market rally. 

NYSE margin debt recently reached its highest level since 2007 before the last major stock market peak and credit crash.  Stephen Suttmeier, technical research analyst at Bank of America, noted that margin debt, rose 28% in March from a year ago to $380 billion. That figure is slightly below the July 2007 peak of $381 billion, although analysts speculate that April’s margin debt totals (which haven’t yet been released) have already surpassed this mark.

Suttmeier told The Wall Street Journal that the currently high margin debt levels are “contrarian bearish.”  While high margin levels have coincided with major market tops of the past, there’s an important twist to this particular indicator.  In order to confirm that a top has been made, margin debt levels normally turn down before major indices like the S&P 500 peak.  See the following graph, courtesy BoA Merrill Lynch.

“It’s no surprise people have been taking on more risk as the market has moved to record highs,” writes Steven Russolillo in The Wall Street Journal.  “But the question is what happens when the easy ride higher turns south and some of that margin debt turns into margin calls?”  The article goes on to warn of a potential selling wave if stock prices reverse and margin calls lead to mass liquidation.  “A wave of margin calls can worsen selling pressure on stocks and was seen as partly to blame for the market’s woes during the financial crisis,” writes Russolillo.

While it’s true that rising margin debt levels should be viewed as a potential yellow flag for the stock market, other indicators don’t yet suggest the rally has reached bubble proportions.  As economist Ed Yardeni pointed out in a recent blog (http://blog.yardeni.com), “Valuation multiples aren’t flashing irrational exuberance yet, but that could change quickly in a debt-financed melt-up of stock prices.” 

Yardeni suggests that while NYSE margin requirements have been unchanged since January 1974, Fed Chairman Bernanke could boost the requirement later this year in response to charges that the Fed’s stimulus program is leading to a stock market bubble. 

Lest investors forget, margin requirement hikes can take a huge toll on investor psychology and can completely take the wind out of a market’s sails.  Remember the gold and silver margin increases of 2011, anyone?