What are Investors' Margin Debt Levels Telling Us?

On Monday we shared that our Psychology Composite had moved to its most bullish level of P1.  Generally, when psychology is at this level, it means that panic has ruled the markets, and the crushed stocks and sectors are likely prone for a nice strong snap-back rally.  Our Psychology Composite has an uncanny record of pin-pointing major bottoms in bear markets or serious corrections, the latter of which we believe we have experienced over the last four months. 

We believe that the market action since early August has marked the peak fear of a correction.  We also believe that the last four months have been a period when this peak fear has been in a digestive state, prior to a return to optimism.  That is what P1 ratings are all about.  That is also what market cycles are all about, and the reason that investors typically don't do well, since the panic at bottoms takes over rational decisions.

In the chart below, you can see how the speculative investor who buys stocks with borrowed money is at the heart of this fear cycle. 

Click on the image above to view a larger chart.

When the increase in margin debt rises dramatically, it is a prelude in almost all cases to a correction or bear market.  Conversely, when you see that margin debt is being reduced, it typically signifies the end of a correction or bear market.  In bear markets, that margin debt moves into deep negative territory, but we continue to believe this is a correction, and the recent drop in margin debt is calling for an imminent rally.

We'll continue to closely watch this indicator, along with the many other indicators that make up the Hays Asset Allocation Model as this market progresses.

Don Hays

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