The Dow Jones Industrial Average plunged more than 1,000 points last week as global economic concerns weighed heavily on Wall Street. Last week marked the worst weekly return for the major averages since 2011.
And Monday didn’t start off any better, with the Dow plummeting another 1,000 points in early trading.
The CBOE Market Volatility Index (VIX), aka the fear index, spiked more than 90% during the week — its largest weekly rise on record. It has continued to rally, gaining more than 40% in early trading today.
In short, panic is starting to set in among investors and traders as they unload massive chunks of their holdings, leading to a veritable stock market meltdown.
But there could be much more bloodshed to come…
Stock Market Meltdown
Other than Federal Reserve easy-money policies that have fueled our current stock bubble, there has been another trait synonymous with previous bubbles: margin debt.
High levels of margin debt show that traders and investors are willing to make a leveraged bet, on the margin, to own shares of a company. The sustained rally the market has enjoyed up until this year has lured many investors into borrowing against their existing equity. But heavy borrowing sets up a dangerous scenario when the market comes tumbling back down to earth.
In fact, high levels of margin debt help to fuel the sell-off.
As investors receive margin calls, they are forced to liquidate positions regardless of where the stock is trading — this is the mechanism that sends the Dow down more than 600 points in a day, panic selling.
It is typically a sign of a euphoric high, which signals a top in the market. The good news is that there is still time to protect against losses.
Margin Debt Signals the Peak
While this bull market has been generally considered one of the most unloved bull markets, margin debt doesn’t support such a claim. Take a look:
As you can see, margin debt has been extremely strong, meaning investors are willing to overleverage their accounts to participate in the bull market.
There is no doubt has the Federal Reserve has fueled this bubble.
Interest rates stuck near zero have enticed investors into risky investing, as margin costs are kept low. Throw in the fact that investors are seeing almost nonexistent gains from risk-free accounts, forcing them to dive into stocks in order to find a decent yield, and you have a dangerous cocktail of heavy market exposure.
With investors at their most overleveraged point in history, stocks have begun to correct. The margin data above is only through June, but these past few days have surely lowered investor confidence in this bull market, and margin debt has likely peaked.
When margin debt peaks, it is accompanied by a peak in stocks, followed by a 50% or more plunge.
As of today, broad stock markets have fallen a little over 10%, so there is plenty of room to the downside, and the completion of the stock market meltdown.
If you have been following our Investment Director, Jeff Opdyke, in his daily articles, you would have been taking some cash off the table as we approached this massive stock market meltdown.
I have been using a similar approach in Pure Income, keeping our portfolio light to take advantage of the sell-off and minimize its impact while offsetting some of our positions with protective put options, which limits our downside exposure.
But the best thing you can do today is make sure you have protection in place for your portfolio. If you haven’t purchased any downside protection such as an SPDR S&P 500 (SPY) put option, you need to do so as an insurance policy.
You will end up paying more for it today than a few weeks ago, but it will serve a similar purpose, to protect you from another 40% to 50% drop that may be inevitable over the coming months.
Editor, Pure Income
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