OPEN APP
Home / Industry / Retail /  Black Friday rout shows dangers of margin borrowing

Small investors are piling into markets using borrowed funds after a long string of gains, but many say the practice increases risks of sharp pullbacks

Friday’s global retreat from riskier assets exposes a vulnerability of the broad market advance of the past year and a half: the rising use of leverage, or borrowed money.

Traders said the Black Friday rout, which hammered stocks and energy prices from France to India to the U.S., doesn’t necessarily presage a broader pullback unless further bad news about the new variant of Covid-19 comes to light. But the reversal underscores the fragility of the rebound from the March 2020 lows, which ranks as the fastest return to record highs following a decline of at least 20% from a previous peak.

Borrowings against portfolios of stocks and bonds, broadly called margin debt, have grown as individual investors have become major players in the stock market. So too have concerns that debt-fueled buying could be a sign of overexuberance, setting the stage for tumultuous trading periods such as Friday’s, when the Dow Industrials posted their largest-ever Black Friday decline and the U.S. oil price dropped 13%.

Investors who have borrowed heavily to fund investments in a rising market are more sensitive to such reversals, analysts and portfolio managers said. At the same time, the Covid-19 pandemic has made investors more vigilant about reducing risk whenever clear threats emerge and piling into Treasurys, which posted one of their strongest rallies during the pandemic era on Friday.

“If stocks start to stumble, investors may panic and rush to sell," said Jason Goepfert, president of Sundial Capital Research. “There is less room for them to maneuver."

Margin borrowings in October were up 42% from a year earlier to $935.9 billion, according to data from the Financial Industry Regulatory Authority, Wall Street’s self-regulator. Meanwhile a measure of cash holdings among individual investors fell to 46% of margin balances, Mr. Goepfert said, the lowest reading in data going back to 1997.

Margin borrowing isn’t the only way investors take on leverage, which can accentuate gains in a rising market but magnify losses when indexes decline. Options trading, which has exploded in popularity, isn’t fully reflected in the data, nor is the debt employed by hedge funds and other institutional investors.

Investors with as little as $2,000 worth of securities in a brokerage account can usually pledge those assets to obtain a loan. Investors need to maintain a specific asset level to avoid having to put more cash into the account or risk losing pledged securities, in what is known as a margin call.

Though margin borrowing has risen sharply during the economic-reopening rally, that isn’t entirely surprising. The figure tends to increase during periods when stock prices rise.

Meanwhile, margin debt relative to the S&P 500’s market capitalization has crept higher but hasn’t hit extreme levels. Borrowings accounted for 2.4% of the benchmark’s value at the end of October, up from 2.1% at the start of 2020. From 2007 to 2018, the figure averaged closer to 3%.

Many investors brush off worries about investor borrowing and other longstanding market risks, such as high valuations and “crowded" trades that are prone to sudden reversals. Friday’s selloff might have been intensified by thin postholiday liquidity, which means trades that are relatively small by the standards of a typical day on Wall Street can move prices much more than they normally would.

For now, many investors say there are few signs that stock bulls have completely lost touch with reality, as has happened during previous bubble episodes.

“I’m looking around for signs of euphoric behavior," said Aaron Smith, a 41-year-old accountant in Waco, Texas, who leverages around a quarter of his $1 million investment portfolio of mostly technology stocks. “At the country club, do they have ESPN on or CNBC? It’s ESPN right now."

But the use of leverage by younger investors is especially concerning, the Federal Reserve said in its latest Financial Stability Report. It said younger individual investors have much higher leverage ratios, leaving them more vulnerable to margin calls and other setbacks when prices fall.

Many Americans turned to stock trading early in the Covid-19 pandemic, armed with stimulus payments and unemployment checks. Brokerages like Robinhood Markets Inc. and Charles Schwab Corp. reported millions of account openings over the past two years.

Jon Renner, a 31-year-old in Phoenix, decided to make a career of stock trading this year after giving up his work as a musician following a 2019 accident that damaged his hearing.

Starting with a few thousand dollars, Mr. Renner said he made some money on GameStop Corp.’s January surge. He then loaded up on shares and options of AMC Entertainment Holdings Inc. His portfolio hit nearly $150,000 before leveling off at about $50,000, Mr. Renner said.

He said he has taken some profits, and AMC still accounts for most of his holdings. Mr. Renner said he leverages anywhere between 10% and 20% to buy more stocks and options.

With no other income other than what he makes from trading, he has little room for missteps.

“If I blow my account up, which is a possibility, it will be much more difficult to repeat what I’ve already done," Mr. Renner said.

 

Subscribe to Mint Newsletters
* Enter a valid email
* Thank you for subscribing to our newsletter.

Never miss a story! Stay connected and informed with Mint. Download our App Now!!

Close
×
Edit Profile
Get alerts on WhatsApp
My ReadsRedeem a Gift CardLogout