Black Friday rout offers lesson on margin debt risks

Market tumult kicked up by new COVID variant reignites concerns around retail investors’ use of leverage

Black Friday rout offers lesson on margin debt risks

Last Friday, news of a new highly mutated variant of COVID-19, called omicron, sparked a sharp selloff across financial markets. As panic spread among investors and countries announced new travel restrictions, US$2 trillion was erased from the value of global stocks.

Oil prices plunged more than 10% on Friday, representing the largest one-day drop since April last year. The Dow Jones Industrial Average fell 905.04 points, or 2.5%, which was its biggest single-day percentage drop since October 2020; the S&P 500 shed 106.84 points, or 2.3%, and the Nasdaq Composite dropped 353.7 points, or 2.2%. By the time the dust settled, all three U.S. stock indexes had logged their worst Black Friday session on record.

The whipsawing in the markets highlighted the fact that as quick as the post-pandemic rebound has been, it’s still not that strong. Much of the activity over the past 18 months has occurred due to increased participation of individual investors, which according to the Wall Street Journal has come with an increase in borrowings against portfolios of stocks and margin debt.

Citing data from the Financial Industry Regulatory Authority, the Journal said margin borrowings in October stood at US$935.9 billion, up 42% from the previous year. Jason Goepfert, president of Sundial Capital Research, told the publication that one measure of cash holdings among individual investors declined to 46% of margin balances, the lowest reading in a record that stretches back to 1997.

“If stocks start to stumble, investors may panic and rush to sell,” Goepfert said. “There is less room for them to maneuver.”

Investors in the U.S. who have at least US$2,000 of securities in a brokerage account are typically able to pledge those assets to obtain a loan. Aside from that margin borrowing, there’s also been an explosion in the use of options trading. Through those types of leveraged investments, many investors have been able to juice the gains in their portfolios amid rising markets, but have also exposed themselves to disproportionate losses when indexes decline.

There are reasons to not be overly concerned about the potential impact of investor borrowing at this point. The thin post-holiday liquidity, for one, could have meant trades were able to move prices much more drastically than they would on a normal day, which could have contributed to the sharp selloff. Many investors also argue that there haven’t been enough signs of excessive exuberance from out-of-touch stock bulls, which were on full display during previous bubble episodes.

Still, the stewards of the financial industry are on the alert. In its latest Financial Stability Report, the Federal Reserve flagged younger investors’ use of leverage as an area of concern; burdened by much higher leverage ratios, younger individual investors are more vulnerable to margin calls and other setbacks, according to the central bank.