May 5, 2021
Trades & Tutorials
By Geoff Bysshe
The stock market is currently in an extremely bullish mode fueled by a "bubble" inside the market that's unsustainable and unpredictably bullish.
Like any bubble…
The heights to which it will push stock prices are unpredictable.
However, unlike most bubbles…
It may be predictable.
This is the third time that this specific type of bubble has developed since 2000.In each of the last two occurrences, there has been an identifiable tipping point at which this bubble has "popped."
And like most bubbles…
When they pop, the market drops significantly.
I'm sure this type of bubble has developed and popped many more times than the two shown below. Unfortunately, the data is only available back to 1997.
However, I think you'll agree that the logic behind how a tipping point or "early warning" and "confirmation" are determined would have worked just as well in prior market tops.
As you'll see in the charts below, there is a and "early warning" that the bubble has popped and then a "confirmation" that the market top should be in place.
The first time in our dataset that this bubble developed and popped was in 2000. When the initial early warning occurred at the end of May 2000, the SPY was trading $142.
After the warning, the market rallied back to new highs but failed to continue. Then at the end of October, the confirmation occurred. Ironically this happened at the same price as the warning from 5 months earlier, $142.
After the confirmation, the SPY lost 46% of its value!
In 2007 the market's pattern was very similar. The "early warning" occurred at the end of October at $147 followed by a confirmation 4 months later at about the same price.
After the confirmation, the market lost as much as 54% over the following 14 months.
As you can see, this has been very timely and given you plenty of time to adjust from a bullish to bearish mindset.
However, it's important to understand how we're tracking the bubble and identifying an early warning because the market will not always respond the same way.
In both cases, the market rallied after the warning, but this doesn't have to happen.
In both cases, the confirmation occurred about 4 months after the early warning and at the same price level, but both the timing and the price similarity are coincidences.
Now let's look at how these warnings are identified and what I'll be tracking for you (if you'd like to be alerted when the next "early warning" occurs) to follow the current market until it the current bubble bursts in what will likely be a similar topping pattern as occurred in 2000 and 2007!
The Secret Is Not Just What To Track, But How To Measure It.
The bubble that we're tracking is the use of leverage by investors. More specifically, it's the amount of margin debt investors have taken on.
You may have already seen statistics on how high margin debt has risen, but it's unlikely that you've seen this application of it.
The most common chart of margin debt is below. It's the total value of margin debt.
This chart is interesting, and yes, it did peak at the same time as the market in 2000 and 2007, but it doesn't tell you when margin debt is too high.
For example, if in 2007, you assumed that the level of $300 billion that proved to be the peak in 2000 was the "too high level," you would have turned bearish almost 2 years too early and missed a 25% move up in the market.
Likewise, if after 2007 you recalibrated your expectations and assumed that the $416 billion level was the new "alert" level, it was not helpful. That level was breached in September of 2013 when the S&P 500 was trading at about the same levels that it peaked in 2000 and 2007!
It could have (and probably did) mislead many investors to believe that the market would form a top!
That was 8 years ago, and the market has more than doubled since!
A Better Way To Pick An Overbought Level
Markets trade, trend, and reverse based on BOTH time and price. Trends that tend to continue are consistent and stable in how much they advance or decline relative to the time it takes.
Savvy traders know that if a market moves "too far too fast," it's likely to reverse, or at least stop.
Not surprisingly, the same rules apply to the amount of margin debt in the market.
Below you'll find a chart of how margin debt has increased over the last 12 months by the black line, and over the last 6 months by the magenta histogram.
As you can see in the chart above, in both 2000 and 2007 margin debt growth over the last 12 months topped out over 60%.
These are extreme levels, but we can do more to identify when they will become a negative factor for the market's trend.
In fact, such elevated levels of debt are indicative of a market that could easily continue higher until the enthusiasm is "popped."
Once It Pops, There Are Two Highs
In both 2000 and 2007, when the rising trend in the absolute level of margin debt reversed, the top in margin debt was set.
However, the top in margin debt does not mean the market's top is set because this is not the only factor moving stock prices.
The market top will be defined by price breaking down below a key technical level and margin debt breaking below its own technical levels.
I will cover the key price thresholds, reversal patterns, and more in a future post (click here or optin on this page to get alerted first when the next post it made).
Below you'll find charts that define the key technical levels that are used to determine the "early warning" and "confirmation" of a top in margin debt. These are the same time points discussed above.
The "early warning" is triggered by absolute margin debt declining below its 6-month average. The "confirmation" occurs when it drops below its 9-month average.
The 2000 Dot.com Margin Debt Bubble Top
The 2007 Financial Crisis Margin Debt Bubble Top
"Optimism vs. Euphoria"
In 1999, Money magazine called Sir John Templeton "arguably the greatest global stock picker of the century."
You may know him for what he's more commonly recognized for, his quote...
"Bull markets are born on pessimism,
grow on skepticism,
mature on optimism and
die on euphoria."
Margin debt is indicating that we're in a euphoric stage.
It's important to keep in mind that the bubble here is not a bubble in valuations, as was the case in 2000. Nor is it a bubble in mortgage lending, as was the case in 2007.
It could be argued that the most influential driving force in the current market is the liquidity being provided by central banks and that history will look back at that as the bubble that popped the market.
We don't need to prove that to be true or false right now.
Margin debt doesn't need to be the primary reason for a significant top in the market. In its current state, it's an indication of euphoria, and once euphoria peaks it's very likely the market will too.
However, it's also important to keep in mind that for active investors, euphoric market conditions can create some of the biggest bullish trading opportunities.
What To Do Now
Unfortunately, margin debt data is only released monthly, and it is reported for the prior month, so it is not as real-time as many other indicators.
As a result, its timeliness will depend on how you'd like to use it.
In the short-term, with the 12-month percent change indicator at euphoric levels and continuing to climb, there is both a high risk of a significant sell-off or a melt-up.
Identifying if either of these two conditions is underway will require additional indicators and analysis.
As a MarketGauge member, you'll find them in our suite of discretionary tools and strategies. A simple use of Real Motion and or Mish's Phases would be a good place to start.
For a longer-term and more mechanical approach, bearish readings in our Risk Gauges available for SPY, QQQ, and IWM in Alpha Rotation would be a good and independent complement to this analysis.
The Risk Gauge for the SPY is also available in BigView and often referred to in the Weekly Market Outlook.
Additionally, this blog post will kick off a special "Margin Debt Bubble Watch" membership which is currently free.
This service will provide you with…
If you'd like to certainly not miss the next "early warning" Margin Debt Bubble alert, click here to register for this free access.