How far could the stock market sink? 1 indicator can contain the answer.

Regardless of how long you’ve been putting your money to work on Wall Street, 2022 has been a challenging year. From the first week of January, which is when the iconic Dow Jones Industrial Average (^ DJI -2.35%) and reference point S&P 500 (^GSPC -3.26%) hit their all-time highs, both indices have fallen into correction territory with losses in excess of 10%.

Meanwhile, technology-driven stocks Nasdaq Composite (^IXIC -4.10%) has performed even worse. After reaching an all-time high in November, it has fallen as much as 31%. This puts the Nasdaq firmly in the grip of a bear market.

Considering the increased volatility and unpredictability that often accompanies bear markets and sharp corrections in major US indices, the big question on investors’ minds is simply this: How far could the market go? of values?

Image source: Getty Images.

This indicator suggests that the stock market may have a lot more to fall

To tell the truth, there is no concrete answer to this question. We will never know in advance when a correction will begin, how long it will last, or how steep the decline will be. In fact, in many cases we can’t even identify the expected cause of a fix until it’s already underway. However, we do have access to economic data, and that may offer clues as to the magnitude of the drop that could await the Dow Jones, S&P 500 and Nasdaq Composite.

In particular, one indicator could be particularly useful in determining how far the stock market could sink: margin debt.

Margin debt describes the amount of money investors borrow, with interest, to invest or bet on securities. While using margin can increase profits if you bet correctly on the direction a stock will move, it can also quickly accelerate your losses if you get it wrong. A bad bet using margin can even result in a margin call, which is where your broker requires you to post additional collateral or liquidate your position at a loss.

As the value added of publicly traded companies has increased over time, the amount of outstanding margin debt has also increased. This is perfectly normal. What is not normal is seeing the amount of outstanding margin debt increase rapidly in a short period of time. In the few instances in the past 27 years where outstanding margin debt rose 60% or more in a single year, the S&P 500 has crashed soon after.

For example, the debt spread soared 80% between March 1999 and March 2000. The subsequent bursting of the dot-com bubble caused the benchmark S&P 500 index to lose about half its value, while the Growth-focused Nasdaq fell nearly 75%.

It happened again seven years later, when margin debt jumped 62% between June 2006 and June 2007. This was just a few months before the financial crisis and the Great Recession took hold and eventually wiped out 57% of the value. of the S&P 500.

FINRA Debt Margin Chart

FINRA debt spread data by YCharts.

Lastly, between March 2020 and March 2021, margin debt increased by 72%. History would suggest that the S&P 500 could ultimately lose about half of its value.

Some caveats to keep in mind

But there are some important limitations and caveats to understand about using margin debt as the ultimate predictor of future stock market movements.

For starters, the factors that lead to stock market corrections and bear markets are unique to each event. In the early 2000s, the dotcom bubble was sparked by the irrational exuberance of investors in dotcom companies. Meanwhile, the subprime housing collapse was the fuel that ignited a wave of bad loans sitting on bank balance sheets between 2007 and 2009.

The current correction in the stock market is a reflection of an unprecedented event taking shape. Never before has the Federal Reserve initiated a cycle of monetary policy tightening, that is, raised interest rates and/or reversed quantitative easing measures, in a declining stock market. Additionally, multiple generations of consumers and homebuyers have never dealt with inflation of this magnitude.

Wall Street loves when the story rhymes. Regarding the current situation, where the Fed is aggressively tightening a sinking market and inflation is through the roof, there is no precedent. This effectively throws the story out the window and further adds to the uncertainty on Wall Street.

The other caveat to keep in mind is that no matter how gloomy the corporate forecasts become, all three major US indices have finally erased all previous corrections and bear markets. Although some declines can take a long time to reverse, such as the Nasdaq’s fall from grace during the dot-com bubble, history shows unequivocally that buying stocks and holding them for extended periods tends to be a lucrative strategy.

A businessman reading a financial newspaper.

Image source: Getty Images.

There are several smart ways to invest during a bear market

In my opinion, none of the three major US indices have bottomed yet. But that doesn’t mean it’s time to run for the hills. Rather, it means investors need to be smart about how they put their money to work.

For example, investors with cash should consider dollar cost averaging on their favorite stocks. Dollar cost averaging involves buying shares at regular intervals, regardless of the share price, or buying when shares reach specific (but arbitrary) price points. Dollar cost averaging takes some of the emotional aspects out of investing, so you won’t beat yourself up if you didn’t buy at the absolute lowest price. Plus, since most online brokers are commission-free, there’s no harm (or cost) in constantly nibbling on your favorite stocks.

Buying dividend stocks can also be fruitful during a bear market, especially when inflation is effectively at a 40-year high. Companies that pay dividends are often profitable on a recurring and time-tested basis. Additionally, studies have shown that dividend stocks have easily outperformed non-dividend-paying stocks over the long term.

Defensive and staple stocks can also be smart buys during a bear market. For example, a crashing stock market will not change the fact that people still get sick and require medical care. This creates a baseline level of demand for drug manufacturers, medical device manufacturers, and health care service providers.

Another example is the actions of electrical companies. Homeowners aren’t going to suddenly change their electricity consumption habits just because the stock market has had a rough couple of months.

Even growth stocks can be a smart way to take advantage of a bear market. Although one would think that value stocks would come into focus during a bear market, studies have shown that growth stocks actually outperform value stocks during periods of economic weakness.

No matter how much the stock market ultimately falls, buyers with a long-term mindset will almost certainly be rewarded.

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