The first thing we need to do is to compare margin debt to credit balances. The ratio of margin to credit balances is less than it was during the Internet bubble but margin debt is still substantially higher than it was in 2000. During the Internet bubble, the ratio between margin balances and credit was almost 5 to 1, which was ridiculous, but we are not in or likely to be in that territory in this economy.
(Read more: Playing with fire? Margin debt most since crisis)
What is more interesting is the peak in margin debt that occurred in 2007. Credit balances increased proportionally to the margin debt going into that peak. In typical conditions, we would expect credit balances to increase when margin-debt levels increase and that is exactly what happened in 2007. The concern is that this relationship does not exist in our current environment.
Right now, margin debt is increasing while credit balances are flat-lining. Therefore, investors are assuming more risk and leveraging their portfolios much more without increasing their credit balances.
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In my research, I discovered that the changes in margin debt since the credit crisis have been directly aligned with Federal Reserve policy decisions. The most interesting divergence coincides with the beginning of the Fed's third round of quantitative easing, or bond buying, which began last September. Exponential margin expansion occurred on the heels of this program's initiation, without increases in credit balances.
If nothing more, this observation tells us that when deleveraging comes, it will be much more violent than what we have seen in the past. The spreads between credit and margin are far too wide, and although proportionally not as disparaging as during the Internet bubble, the risks are quite clear.
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Changes in margin debt can also be used to identify market declines before they happen, because smart money typically begins to deleverage before market declines actually happen. In my definition, smart money is the market as a whole, not just one investor or a group of investors, but smart money is the entire market and the market knows best. If you make a comparison of the changes that happened to the market after a peak in margin debt, you see that those peaks were in 2000, 2007, and 2011. Peaks in margin debt are often a precursor to major market decline.
Since the credit crisis, margin-debt levels have moved in parity with stimulus programs and the expectations thereof. Expectations may play a key role in the peak in margin debt that seems inevitably on the horizon.
— By Thomas H. Kee, Jr.
Thomas H. Kee, Jr. is president and CEO of Stock Traders Daily and founder of The Investment Rate. Follow him on Twitter