To understand the stock market, you need to understand how people buy stocks. People don't buy stocks with cash. They use credit. The only people that use cash are drug dealers and pimps.
Since June 1970, NYSE member organizations needed to report aggregate debits in securities margin accounts, as well as aggregate free credits in cash and margin accounts. In 1970, the total debit balance of member firms was $4 billion. As of the end of September 2022, that balance was $687 billion having almost reached $1 trillion in 2021 (see the chart below).
How does a margin loan work? It uses existing shares, managed funds, and cash as security. These existing assets are used to calculate your Loan to Value Ratio (LVR), which determines how much you can borrow. Most brokers work on 50%. This means that if you have a portfolio worth $1,000, the broker will lend you $500 to buy more shares, Once your borrowing limit is established, you can use available funds to purchase further approved investments (shares, managed funds, etc.). Your new and existing investments are combined to form your total portfolio. Margin rates are low and money is easy.
Interactive Brokers were offering margin loans as low as 2.2 percent in 2021. Is that high or low? As of the end of 2021, there were 15,326 public stocks domiciled in the United States. Of that total, 1,138 had a dividend yield above 2.2 percent. If we weed out the rats and mice and only focus on stocks with a market capitalization of more than $1 billion that number goes down to 621 which is still a decent universe. The market-weighted average dividend of these 621 stocks is 4.98 percent which means that there is a positive carry of almost 3 percent. You can borrow money to buy these stocks and the market pays you just under 3 percent to hold them because your cost of carry is negative. You pay 2.2 percent for the margin loan but you receive a weighted average dividend stream of 4.98 percent. Your net cost is negative 2.78 percent. The market is pouting her lips and fluttering her eyelids. She is offering to pay you 2.78 percent to step inside her boudoir for some carnal excitement. Only Catholic priests and blind men would turn her down.
The U.S. stock market is on steroids – the rally that started in 2009 was not driven by fundamentals. It was driven by loose money. How long can this orgy last? In 2022, we are moving away from the bright lights, diamond-studded roulette wheels, and young showgirls, into the smokey back rooms, sweaty croupiers, and middle-aged cocktail waitresses that look better in the shade. Credit makes the world go around. If money remains cheap, the party continues. When credit starts to tighten, we will see how many investors are caught with their boxers around their ankles and their testicles flapping in the breeze. And credit is starting to tighten as inflation raises its satanic head. If you relook at the chart above, you will notice the strong correlation between the performance of the market and margin lending. Also, if you look very carefully, the red line moves before the red line. As investors start to unwind their margin trades, they need to sell stocks and this forces the market lower. And why are investors starting to unwind their margin trades? Because they are anticipating higher interest rates, For more on the relationship between stock markets and interest rates see (https://www.millionman.net/post/financial-education-why-you-need-to-understand-interest-rate-cycles)
So let me summarise. The majority of stock markets around the world have been in a 40-year bull market since the early 1980s, Sure, there have been crises, crashes, and corrections but the overall trend has been to the upside. Look at the performance of the Dow Jones Industrial Average:
Over the past 40 years, the index has risen from 1,000 points to 30,000 points. That is an appreciation of 30x. Also, notice how both the 1987 crash and the dot.com crash are hardly noticeable on the chart. These appreciations have been fuelled by low-interest rates and an almost zero threat of inflation. Inflation, however, is now starting to raise its head for the first time in decades (thanks to the war in Ukraine and high oil prices) and the response of central banks is to raise rates. The market has already started to react to higher rates which means we could be in for a rough ride in the stock market for the next 6-12 months,