Worrying signs of a build-up of froth in US stocks

Investors are piling into US stocks with borrowed money. Rather than buy stocks outright with their own cash, bullish investors sometimes pledge securities to get loans from brokers, and buy more securities with the money.

This ‘margin debt’ reached a record monthly total of $451.3bn in January. It has risen by a fifth over the past year and now exceeds 2007’s peak of $381bn. In 2009, it slid to a low of $173bn.

Many fear that this foreshadows a sharp market slide. Margin debt reached historic peaks in 2000 and 2007, and everyone remembers what happened next. The trouble is that once markets turn, high levels of margin debt exacerbate the downturn, as investors who have made losses with borrowed money have to sell more assets to cover their losses.

As we pointed out last year, a proportion of investors will always gamble with borrowed money, so margin debt will increase along with the size of the stock portfolios they are borrowing against. With the market at record levels, these have naturally got bigger.

Still, record margin debt is another sign of “froth”, says Kate Warne of Edward Jones, a financial services firm. Others are bubble-like valuations in the technology sector; a very high cyclically-adjusted price-to-earnings ratio of 25 (for the US); the S&P’s 22% increase over the past year amid lacklustre economic and earnings growth; and the deteriorating geopolitical situation. The odds of a nasty correction exactly five years after the post-crisis rally began are rising.

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