Short selling and stocks purchased on margin can offer what some consider a forward indicator as to what to expect in future stock market returns.
Both terms describe ways that stock investors use OPM (other people’s money) to magnify the value of their winning bets (buying on margin) or to actually make money when the market falls in value (selling short.)
Buying on margin means that an investor is borrowing against existing shares of stock they own to purchase more stock. The danger of using stock as collateral for a loan is that the stock can be sold from under your feet in the event of a market plunge. What is left after a precipitous drop is used to pay off the loan, and the investor can wind up with nothing — plus a loan balance to pay off.
A so-called “margin call” describes the situation when your stock has dropped below the threshold of value required as collateral for the outstanding loan, so the investor is forced to sell in a plunging market. The problem is that there is never just one investor. Everybody who borrowed is in the same boat, and this behavior of crowds having to sell is what creates the self-fulfilling prophesy of a downward-spiraling market — a shark feeding frenzy as it were.
On March 30 The Wall Street Journal reported that margin debt climbed to a record in February. As of that month, investors had $528 billion in outstanding margin debt. Historically, margin debt has a bad habit of peaking just before major market declines such as the ones in 2000 and 2008.
Irrational exuberance, “animal spirits” — call it what you will. By now we ought to know that while riding those waves to new high-water marks seen in our investment statements, we should have learned to be wary of that exhilarating “high” we experience right up until the bubble breaks.
Of course, we hope that the forward indicators of future market weakness will be wrong this time and that the market will continue to rise. This time around, for example, the dollar amount of margin debt is at an all-time high, but as a percent of market value it is still short of the record. Then again, that market value as a multiple of earnings is also much higher than the norm (but has yet to break the record). So nobody knows for sure.
Selling short is what an investor can do when they feel the evidence indicates the market is about to drop. The short sale is a way to make money on a falling stock or on an EFT that tracks the market.
Essentially, a short seller borrows stock from a brokerage firm and sells it at today’s price to generate cash. If the price falls, they can use the cash they receive to buy back the stock at a lower price — enabling them to return the shares they earlier borrowed and sold back to their broker. They pocket the difference between the cash they received when they sold the borrowed stock and the amount of the cash they had to spend to buy the stock back.
Investors watch the expansion or contraction of so-called short interest, which is the number of shares held in short positions as a percent of the total amount of shares outstanding. As this percentage increases from month to month, it is an indication of market weakness. While short sellers tend, as a whole, to be pretty successful investors, they can sometimes be wrong — meaning that they have to buy back the stock they borrowed and sold so they can return it to the lenders. If the market spikes upward instead of falling, this can be very expensive.
The lesson here is that many people feel that they can beat the system, and the system offers some arcane financial tools that, if used effectively, can do well for a while. But like anything that looks too good to be true, or that worked well once or twice, the downside in both cases can be gigantic losses that can wipe out the original investment entirely.
Long term, keeping investments simple, lowering expectations and refusing to panic are the better options for most people concerned about what comes after any dramatic run-up of stock prices.