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Investors just got another wake-up call on the bull market

Margin debt is heading lower, suggesting bearishness is setting in

The bull market in stocks just lost a major support: Total margin debt on the NYSE is now in a distinct downtrend.

Margin, of course, refers to what investors borrow from their brokers to purchase securities. The higher the number, the more bullish they are, owing to the fact that they pay interest to borrow the money. The New York Stock Exchange each month reports the total amount among member firms. Late last week, the NYSE released its data for January, and it’s that number that is so worrisome.

It’s not that the raw numbers are alarming: The NYSE reported that total margin debt for January stood at $445 billion, an undeniably big number. But it’s been falling steadily over the past year, from a peak of $466 billion in February 2014. The latest total is now below its average level in the trailing 12 months.

To put this in context, consider that when the bull market began in March 2009 and the Dow Jones Industrial Average DJIA, -0.58% was below 6,600, total margin debt was only $182 billion. As the Dow nearly tripled over the next six years, margin debt also rose steadily — until recently.

Margin debt’s downtrend is bearish, according to research conducted by Norman Fosback, the former president of the Institute for Econometric Research and current editor of Fosback’s Fund Forecaster. “If the current level of margin debt is above the 12-month average, the series is deemed to be in an uptrend, margin traders are buying, and stock prices should continue upwards,” Fosback wrote in his investment textbook “Stock Market Logic.”

“By the same line of reasoning, sell signals are rendered when the current monthly reading is below the 12-month average. This is evidence of stock liquidation by margin traders, a phenomenon which usually spurs prices downward.”

How good a track record does this margin debt indicator have? It’s not perfect, by any means. But its overall record is statistically quite significant. Notice from the accompanying chart that the very close correlation between major bear markets and periods when margin debt is below its 12-month moving average (as denoted on the graph by a ratio reading below 1).

For example, margin debt fell below its 12-month moving average in December 2007, only three months into the 2007-2009 bear market and well before the most punishing months of that bear market. It took a bit longer for this indicator to turn bearish after the Internet bubble burst in March 2000 — six months rather than three — but followers still sidestepped the bulk of the bear market that began then.

The accompanying table reports the indicator’s track record since 1959, which is how far back the NYSE data extend. To calculate the odds of being in a major bull market, I relied on the bull market calendar maintained by Ned Davis Research. Notice that, over the past six decades, the odds of being in a major bull market were better than four-out-five when margin debt was above its 12-month moving average.

When total margin debt, relative to its 12-month moving average, is ...Odds of being in a major bull market
Above81.4%
Below53.9%

In contrast, when it was below its moving average, as it is now, the odds of being in a bull market are much less — hardly better than a coin flip.

The good news here, if there is any, is that the downward-trending margin debt doesn’t guarantee that there is a bear market. Still, there’s no denying that there are now much higher odds that a major bear market has begun.

I want to give credit to MarketWatch reader David Hurwitz for making me aware of this latest development on margin debt. Hurwitz says he has for been following the margin-debt indicator ever since an April 2007 column of mine.

Mark Hulbert