Yesterday, we looked at NYSE margin debt, noting its drop for the second consecutive month since its all-time high in February. Our view has been that the historic level of margin debt is a significant potential risk to the market. So does the recent drop mark an improvement in the risk situation? Not necessarily – and in fact, likely the opposite. Why would a drop in margin debt suggest increased risk? Because 1) it may be the start of a trend and 2) it is coming from an all-time high. As we stated, the high debt level represented significant potential risk to the market. That risk is only unleashed once the margin debt starts to be unwound. If that is indeed starting now, the potential risk will become realized. And since margin debt was at an all-time high, the unwind has a long way to fall.

That brings us to today’s ChOTD. Many observers have noted the divergence in peaks between margin debt and the broad market (i.e., S&P 500) at the past two cyclical tops (2000 and 2007). In each case, margin debt has peaked several months before the S&P 500. What is the cause of this divergence and does it offer clues into the likelihood that a) the top in margin debt is in and b) a potential top in the broad market is forthcoming? The timing of the peaks the past few cycles provides a hint as to where much of the margin may have been focused. In each cycle, margin debt peaked approximately coincident with the hot sector (or bubble) of the time.

In 2000, margin debt peaked in March along with bubble sectors like the Nasdaq, semiconductors and internet stocks. In 2007, margin debt peaked in July, approximately the same time as the hot sector at the time, financials. In each case, the S&P 500 did not top out, based on monthly closes, until several months later.

While there is no way of knowing for sure, based on the timing of the peaks (and the simple fact that the most money chases the hot sector), it is a logical conclusion that much of the margined capital gets directed toward the hot sector, or bubble. Once bubbles pop, they are typically dead money, at best, for some time. Thus, margin debt would be faced with an extended downtrend as losses in that sector mount. And the higher the level of debt, the longer and farther it can potentially fall.

Will this scenario play out again? Considering that the recent bubble sectors like biotech and social media stocks appear to have popped, it is a fair bet that the recent downturn in margin debt has indeed marked the peak for this cycle. Whether it will precede another broad market peak requires a bit more conjecture. History suggests there is a good chance, however. And considering the historic level in margin debt, a substantial amount of risk could be realized.