It’s easy in life to make things harder than they are.
Even the best of us do it from time to time.
The financial industry, from the analysts to the media, is pretty much based on making everything as complex as possible.
They focus almost exclusively on the inconsequential, unimportant, and utterly useless.
You saw the jobs numbers last Friday right? And the GDP growth of 0.7% for last quarter?
And daily updates on Europe, oil, and China too?
You surely have. We all have. That’s all we see.
Don’t get me wrong, they all matter...slightly.
But they are small in comparison to one of the simplest, most critical explanations for the current sell-off and why, even though stocks are down, they’re riskier than they’ve been in months.
Fueling The Fire
In our report on detailing what we called the “Long Crash,” we noted one critical factor that would make any sell-off far steeper than most investors would expect or be prepared for.
Back then we warned about the staggeringly high levels of margin debt and the ripple-effect it would cause when it started to dip.
That’s exactly what’s happening now and investors better get prepared for what will happen next.
You see, margin debt is basically the money an investor borrows from their broker to buy stocks.
There are no loan documents. No credit reports. Or anything like that when you borrow money from your broker to buy stocks “on the margin.”
All you have to do is fill out a two page form (or online questionnaire) to open a margin account and you can borrow up to 100% of your capital to buy stocks.
That’s all it takes. And in a good market when a lot of investors are feeling confident, they do it too.
Of course, buying on the margin is a double-edged sword.
It magnifies the gains when stocks go up and magnifies the losses when stocks go down.
So it tends to make highs higher and lows lower. And that’s the key part when looking at the entire market.
If you recall, we explained at the time:
One of the elements which helped push stocks to all-time highs has been investors buying stocks with borrowed money.
Greed is a powerful force. When investors are confident, they will go “all in” on stocks and many more will borrow money to buy even more stocks.
That’s great when stocks are rising. It’s downright cataclysmic when stocks start to drop like they are now.
We’re seeing this all play out right now.
Aggregate margin debt on the NYSE peaked at more than $500 billion last year, an all-time high.
Since then, a vicious cycle has begun. Stocks fell. Aggregate margin debt contracted. Stocks fell more. Aggregate margin contracted more. And on and on.
It’s been a long time coming and has been entirely predictable.
However, a few weeks ago aggregate margin debt reached a potentially critical turning point.
Mark Hulbert of Marketwatch featured a good analysis of the trend of aggregate margin in This Reliable Indicator Says We’re In A Bear Market For Stocks.
He featured this chart below to illustrate a critical point aggregate margin debt may have reached:
According to Hulbert’s analysis, the aggregate margin debt dropped 10% from it’s highs last month and is now below its average levels for the past 12 months.
That’s the key part right there. So I’ll say it again.
Aggregate margin debt has fallen below its average levels for the last 12 months.
Just like when a stock drops to below its long term moving averages, it’s far more likely to set new lows, margin debt levels are the same way.
This signals something investors should be prepared for right now.
Don’t Buy The Dip
As we’ve said all along, this is not another “dip” in stocks.
Although we’re not calling for an outright crash in stocks, there is something equally as costly for investors not following along.
What we’re witnessing is more of a complete revaluation for stocks than anything else.
That’s actually a good thing.
Look at what is happening in biotech stocks to see what I mean.
Longtime Profit Alert readers know it’d have been harder to find a stronger advocate for the formation of a biotech bubble in these pages back in 2013 and 2014.
The Nasdaq Biotechnology Index was on a steady 430% rise from its 2009 lows to it’s eventual 2015 high.
The run was great, but it caused a serious problem.
At the peak, most of the best news was already “priced in.”
So buying the average biotech stock would have been like risking $1 to make 50 cents.
It was all risk and little reward.
That is all changing fast.
Now, nothing has fundamentally changed with biotech. There are still big prizes for successful drugs. There will be big wins and big losses.
The price for biotech stocks, however, has changed greatly.
The main biotech index is down 39% from its highs last year. And the new price level is a much better risk/reward than it has been in two or three years.
Again, that, for investors, is a good thing in the long run.
Biotech is just one example of this reset. We’re seeing it in Europe, China, oil, banking, and everything else too and a continued drop in margin debt levels will get us to that point where it’s time to be a big buyer again sooner than later.
In the end, this all is really simple and you can choose how to look at it in two ways:
1) The bad news is the high level of aggregate margin debt is making it happen faster than most investors are prepared for.
2) The good news is the high aggregate levels of margin debt are making the reset happen even faster so we can get back into the great opportunities this all will present.
If you’re properly prepared for what’s going on now, understand why it’s happening, and know what to do about it, you’ll choose option #2 and be a much more successful and satisfied investor too.