Looking for greed to banish fear.

Two basic emotions—fear and greed—dominate the stock market. When stock traders are fearful, they sell everything they can, take their money out of the stock market and run to the nearest U.S. Treasury. On the other hand, when investors are greedy, they buy everything they can using their own money, and then they try to buy everything they can using their broker’s money.

But how can you tell when investor sentiment is shifting from fear to greed? Answer: Watch margin debt levels.

Buying Stocks on Margin

Buying stocks using borrowed money from your broker is called buying stock on margin. Current SEC regulations allow you to borrow up to 50 percent of the value of a stock you wish to buy—assuming your broker feels you are worth the risk, that is—which gives you up to 2:1 leverage when you buy a stock.

You can learn a lot about how confident stock traders are in the stock market by monitoring the level of margin debt in the market, and the easiest way to do that is by watching the NYSE Margin Debt numbers.
NYSE Margin Debt

Every month, the New York Stock Exchange (NYSE) releases numbers showing how much money was borrowed on margin to buy stocks on the NYSE. As you can imagine, the amount of stock bought on margin is extremely large, but the total number fluctuates quite a bit based on how confident traders are. When stock traders are confident, they borrow more on margin. When stock traders are less confident, they borrow less on margin.
Check out this chart showing the ebb and flow of margin debt:

As you can see, margin debt reached an all-time high of $381,370 in July of 2007—right around the time when we first started hearing the dreaded phrase “Sub-prime meltdown.”
For a little more than a year after that, margin debt levels were steadily declining as traders slowly scaled back their risk. But in October 2008, traders threw up their hands and started dumping their positions so they could meet their margin requirements.

Watching for the Turnaround

If you want to know when traders are starting to regain confidence in the stock market, watch for the NYSE Margin Debt levels to pick back up again. Once stock traders believe the market is going to turn around, they will start leveraging up their trades again to make as much money as possible, and you can join in the fun.

We started to see some signs of a rebound in the March 2009 data, and we’re still seeing that trend continue.

If you’re looking for another indicator you can use to help you time a market turnaround, check out the Baltic Dry Index.

Image courtesy Walkinboston.