Stock market correction fears rise as margin debt hits record levels

It may not be long before the whole US stock market has a Situational Awareness moment.

At least, that’s the worst-case scenario being mulled by some analysts on Wall Street, who have increasingly turned their attention to one eye-popping statistic in the market: Margin debt held by investors has swelled to records and grown at a pace recently that’s only been seen leading up to major corrections.

The fear is that steep tech sell-off could be the spark that leads the record amount of borrowed cash to combust, triggering margin calls and resulting in a wave of forced selling that derails the bull market.

It may sound like an unlikely scenario, but it’s a growing risk investors need to contend with, especially considering how concentrated the market is in tech stocks and how exposed Americans are to a sudden drop in equity prices, investing pros told Business Insider.

Investors who trade on margin can buy stocks or purchase investment products by borrowing funds from a broker. But if the value of their positions falls below a certain threshold, investors get hit with a margin call, demanding they deposit more money into their margin accounts. If they can’t, brokers can sell their positions, sometimes at a loss to the investor.

It’s what caused South Korea’s stock market to tank this summer. Retail investors in the nation were highly levered and hit with a wave of margin calls when chip and memory stocks began to drop this summer, triggering a spiral of forced selling.

The same dynamic also led to the implosion of Situational Awareness, the highly levered hedge fund run by AI wizkid Leopold Aschenbrenner that bet heavily on chip stocks before being hit with margin calls this summer.

Debit balances in customers’ securities margin accounts hit a record $1.5 trillion in June, according to FINRA data.

Levels have fallen slightly since the summer, but remain elevated. Margin debt clocked in at $1.4 trillion in August, up around 27% over the last year.

Margin debt falling from elevated levels has historically been a warning sign for markets, Peter Berezin, the chief economist at BCA Research, told Business Insider. When margin debt starts to fall, it generally signals low future returns for stocks, he said, adding that he would be worried about a deleveraging wave if margin debt were drop significantly from its summer peak.

“Once that starts, it tends to feed on itself. Because as investors de-lever, that means they have to reduce their exposure to stocks; that pushes down stock prices, which leads to another wave of selling,” he said.

Berezin said investors may be uniquely vulnerable to such a sell-off in ways they haven’t been in the past. He pointed to a few coexisting vulnerabilities that have the potential to make the scenario more dangerous:

• The market is heavily concentrated in tech, meaning a deleveraging wave could be triggered within the tech sector and have an outsize impact on the broader market. The information technology sector now accounts for around 40% of the S&P 500.
• Americans are more exposed to a sudden drop in stocks than they have been in the past, in large part due to how invested households are. US households sat on a record $64.6 trillion in corporate equities and mutual fund shares in the second quarter, accounting for more than a third of all household wealth in the nation, according to Fed data.
• More investors are exposed to leverage, thanks to a wave of levered investment products that have become available in recent years. A Yahoo Finance-Harris survey in September found that 43% of US investors were trading with leverage, such as by trading options or buying stocks on margin. Leveraged ETF assets also hit a peak at around $200 billion this summer, Bloomberg data shows.

“From that perspective, this is a more risky stock market than it was even in 2000,” Berezin said.

Ross Mayfield, an investment strategist and vice president at Baird Private Wealth Management, told Business Insider he believed record levels of margin debt suggested that the rapid selling that tanked South Korean stocks this summer was also possible in the US.

“I do think that there’s maybe more fragility in the market structure just because of all of the different ways we’ve introduced leverage into the market,” he said, though he noted that it wasn’t an existential risk to markets.

There are different ways to measure margin debt that suggest current levels of leverage are extreme from a historical perspective. As a percentage of the US’s total market cap, margin debt remains near its historical 2% average, but as a ratio to M2 money supply, margin debt has reached levels comparable to those seen in 2008 and prior to the burst of the dot-com bubble, according to a March analysis from the financial services firm CGS International.

Since 1997, there have only been three years when margin debt has grown as rapidly on a year-over-year basis: 2000, 2007, and 2021, which all preceded major market corrections, an analysis from Ameriprise Financial found.

Anthony Saglimbene, Ameriprise’s chief market strategist, outlined one scenario in which record concentration in tech stocks collides with record leverage, resulting in a “self-reinforcing” sell-off that hits the market’s most concentrated names.

“When leveraged participants all hold the same names, a factor that is growing, stress up or down can produce larger market swings that may seem out of step with headline developments,” Saglimbene wrote in a note.

There’s no obvious place for investors to hide if forced-selling takes hold, Berezin said. He noted that the deleveraging that came as the dot-com bubble burst came in two distinct waves: The first, which came in early 2000, was a rotation away from tech stocks, in which investors were able to find safety by heading into other sectors of the market.

The second was a broad-based market sell-off that began in 2001, where all areas of the market were badly hit.

Markets look like they’re moving toward the “rotation” phase today, Berezin said, pointing to the recent sell-off in the chips and memory space. He speculated that a broader market sell-off similar to 2001 might not happen for at least several more years.

“It’s probably too early to sound the alarm, but it’s not too early to be worried about what happens once things begin to deteriorate. Because once they do, I think it will feed on itself,” he said.