Margin Debt and Future Market Returns

I see a lot of posts on Twitter and other trading forums regarding margin debt and its relevance for future market performance. Most of these posts point to the absolute amount of margin debt outstanding or the growth rate of margin debt outstanding and suggest that when one or both are elevated it is bearish for future market returns.

I have been unable to find such a connection. What I have found to be somewhat informative is the difference between the margin debt growth rate (12-month) and the price change in $SPX (12-month). Below is a chart that plots the two rates of change since 1971.

And here is a chart that shows just the spread between the two series.

Anyone with a sense of market history can see how the spikes in the above chart line up broadly with prior market tops. The table below shows the average forward $SPX returns from various spread levels.

As can be seen, forward returns when the spread is above 20% are poor. Generally anything higher than 20% is poor and it is slightly poorer the higher you go.

I do not have an explanation for why this is the case. Perhaps it simply reflects more money looking to sell than is looking to buy, so even though people are levering themselves to buy stocks, they are unable to push prices higher because there is too much supply. I suspect that the supply is coming from insiders. IPOs often peak just before market tops as well, which reflect insider selling pressure.

The current value of the spread is just below 20%, after having pushed above 20% briefly in the prior month. This is not a precise timing tool and, given the low number of months in the sample, the statistical relevance is low, so this should not be taken as a sign to sell everything and get out of the market. However, it is something I watch for signs of market euphoria and a reason to be “extra” cautious.