Market Watch : Lower Margin Debt Could Presage a Lower Market

There are few poets on Wall Street, but investors are suddenly finding inspiration in Shakespeare: “Neither a borrower nor a lender be.”

The speculators who had, at one time, borrowed more than $44 billion to finance their stock purchases have paid off nearly $15 billion of their debt. And some $5 billion of that repayment has occurred just since January.

The trend is telling. It says investors are pessimistic about the future of the economy and the stock market. And it says that the speculators of yesteryear have been supplanted by much more cautious individuals.

It also may give insight into what to expect from Wall Street in both the near and long term.

In the short run, so-called margin debt--the amount of money that individuals borrow from their brokers to buy stock--is a “coincident” indicator of market strength, said Anthony M. Sorrentino, chief technical analyst at Standard & Poor’s in New York.

When stock prices are falling and investors are paying off their brokers, look for market prices to slide even further, Sorrentino said. The reason is simple. Repayment of brokerage debt pulls money out of the stock market, which, in turn, depresses prices.

Of course, stock prices do not slide every time investors pay off some of their brokerage debt, and investors don’t pay off their debt every time stock prices fall. But, generally, when the two factors work in concert, it indicates a relatively serious market retrenchment, Sorrentino noted.

Recent history seems to bear out the theory. During two of the past three market downturns, investors substantially reduced their borrowings. And those two downturns were significantly more severe than the one that was not accompanied by a drop in consumer debt levels.

Specifically, between 1973 and 1975, investors paid off more than $4 billion of their brokerage debt, and stock prices fell a whopping 48%. Between 1981 and 1983, investors cut margin debt by $1.5 billion and stock prices fell more than 27%. But in 1976, investors continued to borrow from their brokers, even though stock prices were falling. In the end, prices slipped by about 19%.

The Dow Jones industrial index--which measures the value of 30 Blue Chip stocks--has fallen by about 20% this year.

But for those with a longer-term perspective, falling debt ratios are actually a positive sign, said Hugh A. Johnson, chief investment officer at First Albany Corp.

“When the use of credit to buy stocks becomes excessive, there is usually a day of reckoning,” Johnson said. “Now that there is less margin debt being used, it indicates that the market is healthier.”

Why?

When investors buy with credit, there is always a chance that they will be forced to sell their stocks to pay off their brokerage debt. And such forced liquidations have been associated with major market declines in years past.

But when investors don’t need to worry about their debt levels, they may see falling prices as an opportunity to buy stocks at bargain prices, thus buoying the market, said Geraldine Weiss, editor of Investment Quality Trends in La Jolla.

“This is a very hopeful sign,” Weiss added. “It would indicate to me that the people who want to be out of the market are out. We shouldn’t see a lot of panic selling.”

Weiss still expects a steep, one-day decline if war breaks out in the Middle East. But, she said: “The fact that there is so little margin debt should mitigate the possibility of that decline turning into a rout.”