U.S. Investors Are Doing Something They've Never Done Before, and It Could Lead to a Major Meltdown in the Markets

The stock market is approaching the four-year mark of the current bull run, and investors are just as confident as ever that it will continue into its fifth year. The S&P 500 (SNPINDEX: ^GSPC), Nasdaq Composite (NASDAQINDEX: ^IXIC), and Dow Jones Industrial Average (DJINDICES: ^DJI) are trading near all-time highs as investors remain resilient in the face of multiple headwinds since the bull market started 45 months ago. It seems like every price pullback has been met with investor willingness to buy the dip.

That's pushed U.S. investors to do something they've never done before. Margin debt -- when investors borrow from stock brokers and use their shares as collateral -- reached a record $1.5 trillion in June, up 49% year over year. Add to that the growing popularity of leveraged exchange-traded funds (ETFs) and out-of-the-money options, and investors' risk appetite may be higher than ever. It's all fine as long as there's capital to absorb any pullbacks in stock prices. But as margin balances creep higher, the risk of a market meltdown climbs as well.

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An early warning sign

The growth in margin balances has accelerated during the past year as investors look to amplify their returns. Such sudden growth sometimes is an early warning sign that the market is peaking.

Year-over-year growth in margin balances accelerated to 72% in 2021, nine months before the peak in early 2022. It soared to 63% in 2007, three months ahead of the October peak before the Great Recession. And it climbed a whopping 80% in March 2000, right as the dot-com bubble was about to pop.

It's important to note that we haven't reached those levels (yet). What's more, the record $1.5 trillion in margin debt is still relatively tame compared to the record stock market value. As of this writing, margin balances as a percentage of the S&P 500 market cap are about 2.3%. That's in line with the historical average dating back to 1997, when FINRA started collecting margin balance information.

But investors have never had easier access to leveraged investment vehicles than they do now, which could amplify the impact of margin loans. Leveraged ETFs and stock options have grown increasingly popular over the last few years. You can now buy 2x and 3x leveraged ETFs on many popular individual stocks. The barrier to accessing high-risk options trades is just a couple of taps away on an app. As a result, the stock market's current pricing could be even more precarious than it looks at first blush.

How many more pullbacks can the market absorb?

As mentioned, investors have been eager to buy the dip on any market weakness during the past 45 months. But as debt increases, it becomes more difficult to absorb those pullbacks. Highly leveraged investors may be forced to sell in a market downturn due to margin calls, putting additional pressure on stock prices, leading to more margin calls in less-leveraged accounts, and so on.

As Howard Marks put it succinctly more than 30 years ago: volatility + leverage = dynamite. With more leverage, it doesn't take nearly as much volatility for things to blow up.

While volatility has remained relatively low during the past few years, investors shouldn't get lulled into a sense of security. The S&P 500 trades at roughly 20 times earnings expectations, which is already above its historical average in the mid-teens. Some will point to analysts' expectations for the index's earnings to increase roughly 25% per year for the foreseeable future as a good reason for stocks to trade at a premium. But if those high expectations prove overly optimistic, it could lead to a stark decline in stocks as investors reduce the index's earnings multiple based on lower future expectations.

That's to say, if a big decline hits, investors who avoided over-leveraging their accounts will be best positioned to capitalize, while those who did will be forced to sell.

Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.