While the Dow Jones Industrial Average (INDEXDJX:.DJI) and the S&P 500 (INDEXSP:.INX) hit record highs this week, there are troubling signs that the market’s rally is unsustainable. Investors are using leverage to boost returns, and leverage is hitting record highs. Previous bubbles have been shown to be heavily inflated by investors who are buying stocks with margin debt, and this time is no different. What’s going on, and what can you do to protect yourself?
What is margin debt?
Margin debt refers to a loan you take from your broker to buy stock. With the Federal Reserve keeping rates at all-time lows, margin debt is cheaper than e (NASDAQ:ETFC)ver.
|Loan Balance||Fidelity||Schwab||Interactive Brokers (NASDAQ:IBKR)||E*TRADE||TD AMERITRADE (NYSE:AMTD)|
The dangers of leverage
Over the years, numerous investors have sounded the alarm over investing with borrowed money. Most famously, Warren Buffett has said:
I’ve seen more people fail because of liquor and leverage — leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.
A great example of the perils of investing with margin debt comes from the former third member of Warren Buffett’s trio of investors. Rick Guerin decided he wanted to get rich quick and used leverage to boost his returns. In the bear market of 1973-1974, when the market dropped 70%, Guerin got tons of margin calls and was forced to sell his Berkshire Hathaway shares to pay off the loans. The rest is history, as Warren Buffett and Charlie Munger went on to make Berkshire the powerhouse it is today.
A dangerously inflating bubble
While Federal Reserve Chairman Ben Bernanke said just last week that “I don’t see much evidence of an equity bubble,” I believe the signs of a bubble are growing. At the end of every month, the New York Stock Exchange reports the previous month’s value of margin loans investors hold, as well as cash and credit in those accounts. We have to wait till the end of the month for February’s numbers, but we can see that in January, margin debt climbed to near the all-time highs set in the previous bubble.
Perhaps more ominous, the difference between credit and margin debt in accounts is expanding to near the all time high of -$213 billion that was hit during the Internet bubble.