Despite your experience on Wall Street, 2022 has been a difficult year. Since the beginning of January, when the Dow Jones Industrial Avg. and S&P 500 reached record highs, both indexes have fallen into correction territory with their losses exceeding 10%.
Meanwhile, the Nasdaq Composite (^IXIC -4.41%), which is weighted heavily toward technology stocks, has fared even worse. After soaring to a new high in November, it’s dropped over 31%. The Nasdaq is now firmly in a bear market.
If you consider the increased unpredictability and volatility that generally accompanies bear markets and substantial corrections in the major U.S. indexes, the main question on trader’s minds is this: How far will the stock market fall?
This indicator indicate the stock market might have a lot further to fall
There is no simple answer to that question. We will never know exactly when a correction will begin, how long it will last, or how severe the drop will be ahead of time. In fact, in many situations, we won’t even be able to identify the anticipated cause of a fall until after it has already occurred. However, we can look at economic data to get ideas on how large a drop the Dow Jones and S&P 500 could face, as well as the Nasdaq Composite.
One indicator, in particular, may be quite beneficial in predicting how far the market might drop: margin debt.
The amount of cash that investors are borrowing, with added interest, to bet against or invest in securities is known as margin debt. While using margin may increase your profits if you correctly predict a security’s direction, it can also quickly magnify losses if you are wrong. A poor gamble utilizing margin might result in a margin call, which is when your broker requests additional collateral or will liquidate your position at a loss.
As the value of publicly listed firms has increased with time, so too has the amount of margin debt. This is entirely natural. What’s unusual is seeing outstanding margin debt rise swiftly in a short period of time. In the few instances since 1985 when outstanding margin debt rose 60% or more in a single year, the S&P 500 subsequently fell.
Margin debt, for example, increased 80% between March of 1999 and March of 2000. The benchmark S&P 500 lost around half its value during the subsequent bubble-bursting event, with the growth-focused Nasdaq collapsing by over 75%.
It all came crashing down seven years later, when margin debt increased by a factor of 62 between June of 2006 and June of 2007. This was only months prior to the financial crisis and the Great Recession, which caused the S&P 500 to drop by 57%.
Finally, margin debt increased 72% between March of 2020 and March of 2021. The S&P 500 may drop around half of its value over time, judging by history.