For more than a century, the stock market has demonstrated a knack for climbing the proverbial wall of worry. Despite a laundry list of headwinds, including recessions, depressions, wars, historically pricey valuations, and high inflation, the iconic Dow Jones Industrial Average (DJINDICES: ^DJI), broad-based S&P 500 (SNPINDEX: ^GSPC), and technology-inspired Nasdaq Composite (NASDAQINDEX: ^IXIC) have all motored to new highs.
But when the lens is narrowed to a shorter time frame, say a few years, the outlook for equities becomes far murkier.
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Just as history shows that patience is handsomely rewarded on Wall Street, it can serve as a warning over shorter timelines when one or more red flags crop up. Right now, we’re witnessing the stock market do something that’s only occurred four times over the last roughly three decades — and the previous three instances all ended poorly for Wall Street and investors.
We’ve observed this dubious mark only four times over the last 30 years
The easiest drum to beat on Wall Street at the moment is stock valuations. In early June, the S&P 500’s Shiller Price-to-Earnings Ratio reached 42.84, marking the second-priciest valuation when backtested to January 1871. However, premium valuations may not be the stock market’s most immediate red flag.
Based on what history tells us, outstanding margin debt is the single most worrisome metric for investors.
Margin represents the money an investor borrows from their broker to short-sell (wager against) or purchase securities. Investors pay interest on the capital they borrow from their broker, which can vary based on prevailing interest rates and the availability of a security (e.g., hard-to-borrow securities when short-selling often have higher loan rates).
When margin is used to purchase securities, it’s effectively a form of leverage — and we recently saw what leverage can do to a portfolio, courtesy of Leopold Aschenbrenner’s artificial intelligence (AI)-focused hedge fund, Situational Awareness.
Over multiple decades, outstanding margin debt, as reported monthly by FINRA, has steadily climbed. This is to be expected as the total value of public companies rises over time.
But in those rarer instances when outstanding margin debt goes parabolic over a shorter timeline, it’s consistently proven disastrous for the stock market. Since 1997, there have been four instances in which outstanding margin debt has risen by at least 65% over a short time frame, and the end result for stocks has been downright ugly:
