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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.&nbsp; 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.&nbsp; 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.&nbsp; 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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