During the past few months, the big three indexes — the S&P 500 (^GSPC +0.38%), the Dow Jones Industrial Average, and the tech-heavy Nasdaq Composite — all reached record highs, although they have since pulled back.
That’s left many investors wondering what’s next. Where does the stock market go from here?
Although no one can say with any certainty — anyone who claims to know for sure is selling you something — there’s a market warning light flashing that I think is worth paying attention to. It can offer insight on where history says we might go next.
Index
NASDAQ Composite Index
Today’s Change
Index Level
26,107.01
What is margin debt, and why does it matter?
Margin debt is money that investors borrow from a stockbroker to buy more shares than they would otherwise could afford. They put up the shares they already own as collateral, in the same way that your home backs your mortgage.
Borrowing to invest can help amplify gains. When markets are rising, that borrowed money pours in and pushes prices higher. But there’s no free lunch. The opposite is true when markets fall. The brokers want their loans repaid when the collateral loses value, which means investors are forced to sell their shares to pay them off. This, in turn, pushes prices even lower. A high level of margin debt can turn a normal dip into something worse.
Image source: Getty Images.
According to FINRA — the industry watchdog that keeps track of this — the total amount investors have borrowed as of May (the last month we have data for) was up a whopping 53% from a year earlier.
It’s only the 10th time in history that borrowing has climbed more than 50% in a single year.
A rare spike with an ominous track record
Although 10th place isn’t overly concerning on its face, almost every one of those earlier borrowing spikes happened right before market slumps, including the two biggest market disasters in recent history: the dot-com crash of 2000, when the tech bubble burst, and the 2008 financial crisis, when the housing market took down the whole economy. The only exception was the sharp bounce-back after the COVID-19 shutdowns in 2020 and 2021.
What may be most illuminating is looking at the one-year return after each of these previous margin spikes.
| Month/Year | YoY Margin Debt Change | S&P 500 12 Months Later |
|---|---|---|
| 12/99 | +62.8% | -10.1% |
| 01/00 | +60.4% | -2% |
| 02/00 | +74.5% | -9.3% |
| 03/00 | +80.5% | -22.6% |
| 06/07 | +62.4% | -14.9% |
| 07/07 | +62.6% | -12.9% |
| 03/21 | +71.6% | +14% |
| 04/21 | +61.5% | -1.2% |
| 05/21 | +55.9% | -1.7% |
| 05/26 | +53.7% |
Data source: Brinker Advisor.
In eight of the nine earlier cases, the market was lower a year later.
A fast run-up in borrowing doesn’t guarantee a crash by any means — just look at 2021 when the market returned 14% — but given the historical record, it should make you pause. It’s likely not a good sign.
This is only a pattern, not a promise. It shouldn’t be taken as a reason to sell everything. Critically, even if this means a downturn is coming, it doesn’t tell you when a downturn will start, and it doesn’t tell you how deep it will go or how long it will last.
What history says long-term investors should do now
The real lesson from history is that trying to jump out before a crash and back in at the bottom is a fool’s errand. Almost nobody gets the timing right, and most who try end up worse off. Consider this: Even if you had put your money in at the very peak of the housing bubble, right before the 2008 crash, and simply left it alone, you’d have nearly quintupled your investment in the years since.
What you should do is take this as an opportunity to evaluate your portfolio. Are you invested in companies that you believe in long-term? Are you invested in a diverse array of companies with real competitive advantages and proven profitability?
This isn’t the time to double down on flashy, high-growth stocks that are burning cash and promising future returns.
Patience and temperance are the keys to success over the long haul. On that much, at least, history is clear.
