Key Points
JPMorgan Chase (NYSE: JPM) CEO Jamie Dimon is very clearly telling investors that they need to start worrying. In his company’s second-quarter earnings release, he highlighted geopolitical tensions, inflation, fiscal deficits, and elevated asset prices as areas of concern. And, in an interview with CNBC, he noted that margin debt is at an all-time high. That last one could lead to a downward spiral that breaks the bull market. Here’s what you need to know.
Margin debt: a sign of the times
What’s interesting in the list of concerns Jamie Dimon outlined in his company’s second-quarter earnings is that asset prices are elevated despite the other negatives. Now, there is an old saying on Wall Street that the market climbs a wall of worry, so perhaps you could dismiss this situation. But when you add in record levels of margin debt to the equation, the story takes a very different turn.
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Image source: JPMorgan Chase & Co.
Margin debt is a loan from a broker that is backed by an investor’s portfolio. While the loan can be used for any purpose the investor would like (buying a car, for example), most use the money to buy additional investments. The loan risk isn’t significant because it is backed by the portfolio. However, the broker will require the investor to maintain a certain amount of collateral to keep the loan open. This is where things get interesting.
Modest margin debt is unlikely to be a big issue. But if an investor uses margin loans aggressively, even a modest decline in stock prices could leave them with too little collateral. That would trigger a margin call, in which the broker demands additional collateral. The investor could just add cash to the account, but in most situations, the solution is to sell stocks. (If the investor doesn’t provide additional collateral quickly enough, the broker will step in and sell stocks from the account.)
The scale of the problem is the problem
If one investor gets a margin call, there’s no systemic issue. But if many people receive margin calls at once, it could trigger a wave of selling. That, in turn, could trigger additional margin calls if prices keep falling due to the selling needed to cover them. It creates a downward spiral that could easily lead to a painful bear market. The fact that margin debt is at record highs while markets are still near all-time highs is a big concern, especially given the other negatives Dimon has pointed out.
This doesn’t mean there will be a margin-call-driven downward price spiral. But investors should probably heed Dimon’s warning that there is a significant risk of one occurring. If you are using margin, meanwhile, you might want to consider pulling back a little on the leverage, just in case.
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JPMorgan Chase is an advertising partner of Motley Fool Money. Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends JPMorgan Chase. The Motley Fool has a disclosure policy.
