Monday, August 17
A month after the dot-com bubble back in 2000, the market sent a warning shot. It was April 2000 and stocks collapsed 10% in five days, falling 6% on the last day alone.
The New York Post ran a story about margin calls driving the selloff. The story explained how the final day of the selloff was made worse by margin calls, showing how investors were over-leveraged.
With margin, you borrow against your stocks to buy more stocks. In 2000, investors overborrowed to fuel more stock buying and created a flash crash where they couldn’t afford their losses.
Today, margin debt is growing, nearing all-time highs once again. And when folks invest on margin, they’re using borrowed money to boost returns.
But it cuts both ways.
If you buy a security on margin and there’s a price collapse, your broker might issue a margin call. This is a demand that forces investors to pay for their stock losses in cash. Investors who lack the cash to cover a margin call are often forced to sell securities to cover the difference.
Back in 2000, just about everybody was buying stocks on margin. And then a broad margin call drove the April 2000 flash crash. The S&P 500 underperformed for years afterwards, hitting new highs many years later.
More than two decades have passed since the dot-com bubble burst. Yet investors seem to have forgotten the lessons.
Margin climbs through bull markets and peaks near market tops. Today that metric is near the peak levels in 2007. Back then, margin debt growth topped out at 60.2% year-over-year. We’re now at 54%.
Perhaps margin calls are evidence of overbought conditions.
Daniel A. White is an investment advisory representative of and provides advisory services through CoreCap Advisors, LLC. Daniel A. White & Associates and CoreCap Advisors are separate and unaffiliated entities.