Stock-Market Rally Watch, Part III — Money and Markets

Stock-Market Rally Watch, Part III — Money and Markets

In my past two Money and Markets columns I discussedmarket valuation and the underlying trend for stocks. Today let’s dig deeper into a more subjective, but important, indicator: sentiment.

Accurately measuring stock market sentiment, or the confidence level of any financial market, is a tricky business. Such a task involves understanding emotion and psychology, but two items caught my attention recently.

1. Borrowing to buy stocks has hit a record high.

According to the New York Stock Exchange, total margin debt recently rose to a new all-time high. Margin borrowing reached a record $401.2 billion in September.

It would appear that investors, desperate to catch up with the market rally, are eager to get more bang for their buck by leveraging up to buy more shares with borrowed funds. This measure is now in uncharted territory. In fact, total margin debt is roughly $20 billion higher now than it was just before the last major stock market peak in 2007.

While some see this as a measure of confidence in the 25 percent gain in the S&P 500 this year, others see it as a troubling sign. After all, how can chasing stocks with borrowed money at these levels be anything but pure speculation?

Sam Stovall of Standard & Poor’s put it best: “If somebody is willing to borrow money to invest in stocks, they must have a very high confidence level. And if everybody’s so optimistic, who’s left to buy?”

However, we must be careful not to confuse cause and effect. Or as my colleague Bill Hall says: “To be a successful investor, you’ve got to get the sequence correct.”

Click for larger version

There is a high positive correlation between margin debt levels and stock market performance — they tend to move together. In fact, growth in margin borrowing helps explain the strong upside move in stocks, with only minor corrections along the way.

Keep an eye on the growth rate in margin borrowing instead of the absolute level of margin debt, as staggering as it may appear. Margin debt is growing at an annual rate of 27 percent, as you can see in the lower panel of the chart above (black dotted line). That might sound high, but, historically, it’s nowhere near previous peaks.

When stocks topped out in 2000, margin debt was growing 68 percent, according to Merrill Lynch research. And just before the peak in 2007, it was expanding 78 percent.

Reaching those levels would be a red flag, but we’re not even close now.

The real trouble starts when margin debt stops growing at a fast pace while stocks keep rising because, at that point, the bull market is running on fumes.

That pattern played out in 2000 and 2007, when robust growth in margin debt suddenly reversed before stocks peaked and posted epic declines.

By all means, keep an eye on margin debt, and it’s OK to be concerned about too much speculation with borrowed money. But the growth rate is the real indicator to watch because, when it reverses, the bull market is likely to come to an end.

2. Bearish sentiment is dangerously low.

Of more concern to me is that bearish investors appear to be on the endangered species list these days, or at least they have gone into hibernation.

Click for larger version

The folks at Bespoke recently posted the chart above on their website, which measures bearish sentiment among individual investors (blue line) compared with the S&P 500 Index (red line). You can see the number of bears fell to 17.6 percent recently, the lowest since January 2012. That tells me most investors are complacent.

A similar survey from Investors Intelligence polls the percentage of bullish or bearish advisers among newsletter publishers. That indicator recently fell to 15.6 percent bears, the lowest in more than four years. It’s also less than the previous low set in April 2011. Not long after that, the S&P 500 tumbled nearly 20 percent in the late summer of 2011.

Click for larger version

Remember, like most sentiment studies, these are contrary indicators, so extreme bullishness (or an absence of bearishness) is a danger sign. What they’re saying right now is that most investors are pretty bullish and not expecting, or prepared for, a market correction.

Granted, indicators such as margin debt and sentiment aren’t always useful for making investment-timing decisions. For instance, you can see in the chart above that when bearish sentiment reached such extreme lows in 2011 and 2012, the S&P 500 kept climbing for several more months before corrections finally arrived.

But these and other sentiment indicators are more important than ever as the S&P 500 reaches new records. When individual investors have nothing to fear and throw caution to the wind, when margin borrowing is rampant and when no bears are roaming Wall Street — that’s when I worry this may be as good as it gets.

Good investing,

Mike Burnick

Mike Burnick, who has over 25 years of professional investment experience, oversees the Wealth & Liberty Alert newsletter with Charles Goyette and is a contributor to the daily newsletter Money and Markets.

Mike has been a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. He also held the position of investment research analyst and Director of Research for Weiss Capital Management, where he assisted with trading and asset-allocation responsibilities for a $5 million ETF portfolio.

The investment strategy and opinions expressed in this article are those of the author and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

See the article here: 

Stock-Market Rally Watch, Part III — Money and Markets

See which stocks are being affected by Social Media

Share this post