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The Rising Tide of Liquidity, Part 2

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A good couple of posts from The Big Picture (see the first and second) on the increase in margin debt. The data comes from a Wall Street Journal piece:

Such debt is accumulated by investors who trade “on margin” with funds borrowed from their brokers. As tracked by the New York Stock Exchange, margin debt rose to $270.52 billion in November from $221.66 billion at the end of 2005, the first time in more than six years that margin debt has topped $270 billion. December numbers will be available later this month.

That 22% increase left margin debt not far from the record of $278.53 billion, reached in March 2000 as the Nasdaq Composite Index was setting a record high. Last year’s rise in margin debt occurred against a bullish backdrop for stocks, with widely followed market indexes notching double-digit percentage gains.

As the story observes later, high levels of margin debt are often signs of speculative fever. Barry Ritholtz is too sensible to stick his neck out and risk sounding a premature warning (“if you must forecast, forecast often”), but he doesn’t like what he sees: “While rising, NYSE Margin has not yet hit the levels that raise red flags. However, it is getting increasingly close.”

One of the metrics he suggests looking at, and I’d be interested in following, is margin versus total market cap. I dimly recall that margin levels were quite high before the 1987 crash, and I’d be curious to see how they tracked over time.

This signal by itself is troubling, and it is consistent with signs of excessive liquidity in other markets that we’ve commented on earlier, such as tightening credit spreads, explosive growth in the CDO market, and hedge-fund speculation driving prices in the oil market. Yet there is a good deal of optimism in the press and seemingly in the business community, despite the sucking sound of dollars and lives going down the drain in Iraq, a tense geopolitical climate, and an isolated America (well, we do have Israel, Poland, and Australia in our pocket). But toppy markets are immune to bad news.

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