Jamie Dimon oversees the largest bank in the U.S., serving as CEO and Chairman of JPMorgan Chase for the last 20 years. That gives him a front row seat to the financial markets, and he’s never been shy about sharing what he sees with the investment community at large. When he has something to say, it’s worth paying attention to.
Dimon recently shared some insights about the current market environment that should give investors pause. With valuations for the S&P 500 (^GSPC +0.26%) and Nasdaq Composite (^IXIC +0.54%) stretched, Dimon shared a warning that the market is in a precarious position.
These nine words explain the added risk in today’s stock market.
JPMorgan Chase CEO and chairman Jamie Dimon. Image source: JPMorgan Chase.
“There’s a lot of margin debt you don’t see”
In a recent interview, Dimon explained that margin debt is at its highest level ever. Indeed, margin balances topped $1.5 trillion in June, the highest on record and up 49% year over year. It’s important to note, however, that, as a percentage of the S&P 500 market cap, margin debt is around average.
That’s why Dimon’s warning is so pertinent. “There’s a lot of margin debt you don’t see,” he said. He noted prime brokerage debt, hedge funds, Treasury arbitrage, and leveraged ETFs as examples of debt that won’t show up in the numbers reported by FINRA each month. “So market leverage is pretty high.”
Dimon noted that when leverage increases, you have a higher chance that something will disrupt the market and lead to a significant downturn. While leverage has allowed stock prices to climb higher quickly, it could also lead to rapid drops in the market. A drop in prices could create a cascading effect, leading to forced selling, pushing prices even lower, and resulting in more forced selling in a vicious cycle.
We saw how rapidly that can play out in pockets of the market when hedge fund Situational Awareness was forced to sell significant positions in its artificial intelligence stock portfolio last month. A broader market downturn could affect many more investors.
What does history say comes next?
It’s not just the level of debt that investors should be concerned about, but also how quickly they are increasing leverage in their portfolios. A rapid increase in margin debt has historically been tied to a market downturn within the next 12 months.
As mentioned, margin debt climbed 49% year over year in June. There have only been three other periods since FINRA started collecting data on margin debt where investors have levered up as quickly.
- In December of 1999, margin debt increased more than 60% year over year to $242 billion. Debt reached almost $300 billion in March, up more than 80% year over year. That month, the dot-com bubble popped.
- In May of 2007, margin debt climbed 50% to $382 billion. Debt peaked two months later in July at $416 billion, up 63% year over year. In October, the market peaked ahead of the great financial crisis.
- In February 2021, margin debt climbed 49% to $814 billion as retail investors piled into meme stocks. Debt climbed even faster the next month and continued to grow through October. In January of 2022, the S&P 500 started its decline toward another bear market.
It’s worth noting that margin debt climbed faster in April and May than it did in June, so the clock may be ticking. And if there’s a lot of margin debt we don’t see, actual use of margin may be growing even faster.
It’s not the debt, per se, that gets the market into trouble. Rather, it’s what the use of debt says about investor behavior. Investors will increase leverage when they’re optimistic about the future. They get greedy. But if you follow Warren Buffett’s investment philosophy, an increase in margin debt and overall market leverage should be a reason to be fearful. Indeed, the last three times we saw such a rapid increase in margin debt, it indicated market overconfidence. Now is the time to exercise caution and maintain appropriate levels of leverage in your portfolio.
