Does Highest Ever Margin Debt Create Perfect Storm for a Stock Market Crash?

In a new research report, the market strategists at Deutsche Bank said that it is time to start getting nervous. Excessive margin debt can lead to panic selling if the market takes a steep leg down. Margin calls for people who have borrowed money to buy more stock often exacerbate normal stock selling as they are forced to sell stock to meet margin requirements. This can feed on itself and can turn a minor correction into a landslide. The Deutsche Bank team also has spotted eerie similarities in the current margin debt explosion to the 1999 to 2000 technology bubble and collapse, and the great financial crisis of 2007 and 2008.

We have suggested for some time that any current additions to portfolios should be done carefully by scaling in stock purchases or buying partial positions and waiting for better entry levels. We also have suggested investors should review their portfolios for big gains. It makes sense to take the big winners and pare those against some losses and go to a cash position after a four-year run.

What else can investors do to protect their investment portfolios? We have some tried-and-true ideas that may help readers to sleep better at night.

1. Take profits and go to cash. Lower your equity holdings to 50% or less of your total portfolio.
2. If you are reluctant to sell winners you think will go higher, try the old Wall Street standard: sell half and keep half. The thinking is that if the stocks go higher you still have a position and made the right call. If they go lower, you sold stock and made the right call.
3. Sell covered calls on winners at or above where you are willing to sell the stock. Take the proceeds from those covered calls and buy significantly out of the money S&P 500 index puts. With volatility and the VIX, which is the volatility index measure, at record lows, the out of the money puts will be cheap. Think of it as free portfolio insurance.
4. Buy the ProShares UltraPro Short S&P 500 (NYSEMKT: SPXU). This exchange traded fund (ETF) is two times short the S&P 500. It does not track perfectly, but for every percentage point the S&P 500 goes down, this should go down close to two.

Investors need to remember that no rally or sell-off goes on forever. We have had a significant run since the market lows after last year’s presidential election. With the exception of a quick 5.8% sell-off in May and June, the market has gone up pretty much unabated. It is also critical for investors to keep one other old tried-and-true Wall Street adage handy: Bulls make money, bears make money, pigs get slaughtered. Good advice to use when considering what to do next.