Recent research shows that margin capacity of investors is a reliable predictor of market movement
Market observers and investors around the world are wondering about the sustainability of the current market bull run. S&P benchmark has climbed 22.9 per cent and Sensex has risen by 26.89 per cent in 2021. Although it is very difficult to predict the market behaviour, a few indicators can provide signals on the future direction.
A research paper authored by Prachi Deuskar, Nitin Kumar, and Jeramia Poland provides insights into how the behaviour of investors predicts market returns. The paper explores the possibility of using signals based on the margin trading behaviour of potentially informed investors.
Margin trading involves borrowing money from a brokerage firm to execute trades.
It requires the trader to place a minimum amount of cash, technically called the margin requirement.
The margin requirement is calculated as a percentage of the total purchase value of shares in the margin account. It could vary from 25 per cent to 50 per cent depending upon the broker.
How margin trading works
If an investor buys shares worth Rs. 20,000, a margin requirement of 25 per cent would mean the investor has to place cash of Rs. 5,000 and the broker will provide the remaining Rs. 15,000 as debt. 25 per cent margin essentially means that the broker will provide debt at three times the value of the investor’s equity.
Now, suppose the value of shares rises from Rs. 20,000 to Rs. 24,000, the investor’s equity will rise from Rs. 5,000 to Rs. 9,000. As the broker can provide debt of up to three times the investor’s equity, this would amount to Rs. 27,000, which is the debt capacity. Once the actual debt is subtracted from the debt capacity, we get the margin capacity.
Debt capacity of the investor in our illustration is Rs. 27,000 and the actual debt taken is Rs. 15,000, so the investor has a margin capacity of Rs. 12,000. An investor can utilise this margin capacity to borrow more and invest further. If the investor does not utilise this margin capacity and holds back from investing, it suggests caution on his/her part. High margin capacity indicates that investor portfolio has generated strong returns in the past, but is not optimistic about the future.
Thus, high margin capacity captures the pessimistic sentiment of potentially better-informed and sophisticated investors. As expected, the paper finds that the total margin capacity across all investors is inversely proportional to future S&P 500 returns over periods up to one year. This happens because investors who accumulate margin capacity are better-informed and choose to borrow less in anticipation of lower cash flows and increased risk.
Margin capacity in the US remained low through the 1980s and 1990s, during which the stock market performed spectacularly well following the optimism of the Reagan years and IT stock mania of the 1990s. Margin capacity is also a better predictor during times of contraction. It experienced a large increase in 1999 before the dot-com bust of 2000 and again before the 2008 financial crisis. However, its prediction of the stock market crash at the onset of the Covid pandemic was not strong. Yet in the post-pandemic months, the forecasts were in line with the hypothesis of the paper.
Margin capacity was relatively high during Q1 and Q2 of 2021, thereby predicting correctly the relatively low returns of 4.6 per cent in Q2 and -1.9 per cent in Q3 for the Dow Jones index. Margin capacity dropped in Q3 from the highs of Q2, and as expected Q4 delivered higher returns at 7.4 per cent. Margin capacity in Q4 increased very slightly, suggesting the Dow Jones index would remain stable without strong movements in either direction.
As we come back home to observe how these trends hold for the Indian market, we rely on proxy indicators that capture the behaviour of sophisticated investors. Loan book of brokerage firms is an indirect measure of the debt levels of traders. Many broking firms have declared their Q3 results and the client funding book has grown at a slower rate than previous quarters.
ICICI Securities increased its loan book from Rs. 5,902 crore to Rs. 7,103 crore during Q3 with a growth rate of 20.4 per cent, which is lower than Q1 growth of 64 per cent.
Similarly, Angel One reduced its loan book from Rs. 1,778 crore to Rs. 1,514 crore during Q3. This slowdown in client funding could mean that investors engaged in margin trading are anticipating lower or even negative returns in the next few months.
Rising commodity prices and the US Fed’s imminent tapering may hit FII inflows, while strong recovery in India, and announcements of major reforms in the Budget could provide resilience in the market.
In conclusion, most signals indicate some level of stability in future market movement. But even these predictions are reliable only for short time horizons spanning 2-3 months.
The writer is a Research Associate at the Centre for Analytical Finance, Indian School of Business
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