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<p>Margin debt as a percent of nominal GDP is one of the most useful tools for monitoring leverage and excesses in the stock market.&nbsp; Margin debt represents the amount of money borrowed by investors to buy stocks on margin, and it has mattered historically for two reasons. &nbsp;First, it’s a measurable indication of the public’s appetite for risk and the degree of speculation in the equity market. &nbsp;Second, it represents “hot money” – or the funds that will head for the exit quickly at the earliest sign of trouble or when margin calls hit and leveraged positions must be sold. &nbsp;As such, when margin debt is advancing alongside the stock market, it typically means that investor psychology is supportive and that the bull market has further to run.&nbsp; Conversely, distinct downturns in this measure have historically tended to precede or coincide with peaks in the equity market (see graph below).</p>
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<p>The level and trend in margin debt is very important, but so is its rate of change.  Parabolic rises in this measure inherently accompany periods of strong returns; yet they are also indicative of a high degree of equity market risk and have thus historically preceded major bear markets.  However, it is only a steep decline in margin debt which signals that a market top is likely in place, as many speculators are likely being forced to unwind their leveraged positions.  Watch this indicator to gauge the amount of leverage in the equity market as a reliable warning flag of a market top.</p>
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