The U.S. stock market keeps finding reasons to be cautious, and it keeps finding reasons to ignore them.
The latest warning sign — following underperformance by small-cap stocks, record inflows into exchange-traded funds and high levels of political uncertainty — is margin debt, which is seen as a measure of speculation and just broke a record that has stood for nearly two years.
According to the most recent data available from NYSE, margin debt hit a record of $513.28 billion at the end of January, topping a previous record of $507.15 billion that had held since April 2015. Margin debt refers to the money that investors borrow to buy stocks, and high levels of it, in periods of market volatility, and can lead to sharper declines. Records preceded both the dot-com market crash and the financial crisis.
However, expecting a similar correction because debt is at a record now would be “naïve,” said Jeff Mortimer, director of investment strategy for BNY Mellon Wealth Management.
“This isn’t a signal to me that markets are reaching an exuberant level like they did in the 1920s or 1990s, when speculation was rampant,” he said. “What our clients are doing is borrowing against the portfolios because interest rates are so low. They’re not leveraging up because they see the market exploding to the upside; they’re using leverage because they can pay it off at any time.”
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Record levels of margin debt do correspond with lower odds for future market returns, as well as smaller gains by the S&P 500
but the impact isn’t strong enough to change market direction, according to Bespoke Investment Group.
Following a period with a record margin debt, there is a 61.9% chance that the S&P 500 will be higher three months hence; historically, it would have risen an average of 1.1% following such circumstances. Without a record, those statistics shift to a 65% chance and an average rise of 2.1%.
Similar results are seen over longer timeframes. Six months from a period with a record, the market has a 64.4% chance of being higher, with an average gain of 3.6%, compared with 68.2% odds and an average return of 3.9% for a month without a record. Looking out over a year, the market is positive 63.1% of the time following a record, compared with 74.8% without one; the average return is 6.9% after a record compared with 8.1% without.
Those stats may give investors pause in the current environment, especially given elevated valuations and high levels of policy uncertainty, but high debt regularly occurs with little obvious impact on the market. While nearly two years have passed since the last occurrence, records are not infrequent. According to Bespoke Investment Group, records occur in 23.2% of all monthly readings.