The Bull Market's Middle Innings

This essay was originally published in DailyWealth Trader, a daily trading advisory, and has been adapted. To learn more about this service, click here.

One month after the dot-com bubble peaked, the market sent a warning shot...

It was April 2000, and stocks had collapsed 10% in just five trading days – falling 6% on the last day alone.

As the dust settled over the weekend, the New York Post ran the following headline...

"Margin Calls Tied to Big Sell-Off."

The Post explained that the final day of the sell-off was made worse by margin calls.

In short, investors were overleveraged. They overborrowed to fuel their stock buying... and created a mini flash crash when they couldn't afford their losses.

Today, margin debt is back on the rise. The level of growth in margin debt is nearing all-time highs once again. But as we'll explain, that doesn't mean this bull market is over just yet...

When folks invest on margin, they borrow money from their brokerage to buy stocks with leverage. This leverage can boost potential returns.

But it cuts both ways...

If you buy a security on margin and the price collapses, your broker might issue a margin call. This is a demand that forces investors to pay for their stock losses in cash.

Investors who lack the cash to cover a margin call are often forced to sell securities to cover the difference.

And in 2000, just about everyone was buying stocks on margin.

A broad margin call drove the April 2000 flash crash. And the S&P 500 Index underperformed for years afterward. Take a look...

It took years for stocks to reclaim their all-time high.

More than two decades have passed since the dot-com bubble burst. Yet investors seem to have forgotten the lessons from that flash crash...

This Warning Sign Isn't Flashing Red Yet

Increased margin purchasing today could signal that the market is getting frothy.

We can see how much leverage folks are using to buy stocks using margin-debt data from the Financial Industry Regulatory Authority ("FINRA"). This metric shows a year-over-year ("YOY") percent change in how much margin debt the market has taken on.

Margin debt tends to climb through bull markets... and peak near market tops.

Today, this metric is near the peak levels from 2007. Take a look...

In 2007, margin-debt growth topped out at 62.6% YOY. Today, we're nearing that high, with YOY growth of 53.7%.

However, there are a few reasons why we're not turning bearish yet...

First, the chart above focuses just on margin-debt growth. But compared with the size of the overall market, that total is much smaller today than it was in 2007. We can see this by comparing FINRA's margin-debt reading with the total market cap of the S&P 500.

By this metric, we have a long way to go before we hit the ceiling. Take a look...

Margin debt is on the rise relative to the broader market. This means that margin-debt growth is starting to outpace rising stocks. But it's not even close to the top of its range – which means the current bull market can continue.

In short, margin debt needs to be on your radar today. It's approaching a level that typifies market peaks. That itself won't kill the bull market... But it does show us that the cycle is in the middle innings.

That's why it's important to keep a disciplined strategy. If you don't have one in place already, it's easy to get started. Tools like proper position sizing and trailing stops can protect your principal investment regardless of where we are in the cycle.

We aren't panicking because of the mounting margin debt. But this moment serves as a great reminder that stocks will eventually go down.

Good investing,

Chris Igou

Editor's note: Every bull market creates new winners... and leaves yesterday's favorites behind. That's why MarketWise CEO Dr. David "Doc" Eifrig built his first-ever stock system using the same technology Elon Musk uses to track satellite systems. Doc's latest research is designed to help investors identify new potential winners as this bull market evolves.