It's happening again. The amount of margin debt balances at New York Stock Exchange member firms fell to $473,412 billion in August, down 2.9% from September. It is the 2nd consecutive monthly decline and the first back-to-back monthly drop since December-January.

The importance of these figures is highlighted by the historical relationship between peaks in margin debt, and tops in the stock market, typically measured by the S&P500.

Margin calls & forced selling

As markets enter the early stages of a rally, smart money (hedge funds, index funds) usually leads the ascent until it is joined by retail players to trigger the next buying wave. As the rally sustains itself to higher levels, existing and new payers add on to positons with varying use of leverage (buying on margin). Once markets peak out and/or start to pull back, buyers on margin are obliged to close or pare long positions as margin calls creep in. Clients' losses at member firms escalate especially as soaring volatility triggers the cascading of stops, prompting further market downside.

The high correlation between margin debt and equities reflects the increasing use of debt in purchasing stocks by institutional and retail investors, shedding important light on the circular loop between price performance and the use of margin debt.

1-3 month lags

July 1998 - The stock market top of July 1998 coincided with the peak in margin debt before the decline was propagated by the EM fallout & LTCM collapse.

March 2000 - The peak in margin debt of March 2000 coincided with the market high in the S&P500 right before the burst of the dotcom bubble, which was intensified by a new generation of margined trading, made easy by online trading.

July 2007 - The peak in margin debt of July 2007 occurred three months prior to the pre-crisis top in the market.

The 1-month lag has reappeared as the latest margin debt figures show leverage has fallen 7% from its April peak -- one month prior to the record high in the S&P500 and the Dow.

Margin buying & forced selling

The escalation and subsequent decline in margin debt highlights the risks of speculative stock buying at a time when equities are increasingly vulnerable to contracting earnings growth, slowing global trade, deepening China macro retreat, plunging commodities, falling capex and +$1.5 trillion in cancelled oil projects. The other risk to equities is the back-up of bond yields in an increasingly thin global bond market.

This will not help stock valuations, especially as chest-thumping reminders from Fed hawks fuel the risk of higher yields. And the last thing that's needed is a bout of forced redemptions from hedge funds and margin calls by retail investors.

How I used margin debt in January 2008 and October 2008 to forecast further damage in equities

Margin debt can best be utilized for continuation patterns during selloffs rather than timing of turning points. On January 2008, margin balance helped me make the case for an additional 25% decline after equities had already fallen by 14% from their peak.

Then in October 2008, as stocks had plunged 25% from their 2007 peak, we remained negative on stocks to the extent of predicting further Fed easing against the prevailing market consensus, which leaned towards US rates reaching a bottom at 2.0%.