With inflation persisting and a recession seemingly inevitable, the outlook for the stock market looks bleak. But investors should remember that the stock market is looking ahead, so even if the current macroeconomic situation looks bleak, stocks don’t need to continue bleeding.
In fact, the US investor sentiment spread is almost neutral at around -2%. Anything above 0% indicates bullish sentiment while anything negative is bullish.
US Investor Sentiment, % Bull-Bear Spread Data by YCharts
As you can see from the chart above, market sentiment has decreased by -40% through September.
While the chart above suggests a capitulation, there’s another indicator I’ve been watching closely: margin debt.
I believe that the decline of the peak could suggest that investors are close to a bear market.
Image source: Getty Images.
What is margin debt?
Buying stocks on margin is basically just investing with borrowed money. As greed increases in a bullish market, investors begin to use more and more margin until eventually the market crashes and brokerages begin asking investors to cover their debts.
This is known as a margin call, and when it happens on a large scale it usually signals the end of a bull market.
Each month the Financial Industry Regulatory Authority (FINRA) publishes the total amount of margin used by investors. Tracking this data can give you an indication of where investors are in the market cycle (ie, the market is excited if the margin is rising, and the market is fearful if it is falling).
Main map to watch
I’m particularly interested in changing the margin for debt S&P 500. Historically, as margins increase faster than the market, investors can expect a crash in the near future. Conversely, if it starts falling faster than the market, it could be a sign of capitulation.
FINRA Margin Loan Data by YCharts
As you can see in the chart above, the level of marginal debt has fallen sharply. Most notably, leverage has been hit harder than the general market.
Let me be clear: This does not mean that this bear market has bottomed out. There are many examples throughout the history of the stock market where stocks continue to decline despite declining margins.
But recent history shows that this is a good sign for market recovery, and investors should keep an eye on the October margin numbers, which FINRA will release in the third week of November.
This does not change anything for long-term investors
Monitoring and analyzing the macro situation is a smart exercise for investors, but it should not change the way they invest. Even the smartest economists are more wrong than right in their predictions.
When you try to pay down time, you run the risk of your money sitting on the sidelines uninvested. The old market slogan “timing the market is about timing the market” rings true today more than ever. Long-term investors are best off continuing to buy great companies regularly rather than trying to predict exactly when the market will start to recover.
That being said, a little macroeconomic analysis is still a worthwhile endeavor as long as you don’t base your investment strategy solely on your results.
