The most common explanation of the last U.S. stock market crash is the decelerating Chinese economy. However, investors should not forget about the all-time high margin debt. What does it mean for the global economy and the gold market?

China is the second largest economy in the world, therefore it is an important contributor to the growth of global GDP and significantly affects the commodity prices. However, there are some voices that the possible impact of the Chinese slowdown on the U.S. economy is a bit exaggerated. For example, according to Goldman Sachs, the correlation between U.S. and Chinese economic growth is relatively low and a one percentage point drop in Chinese growth would translate into only a 0.06 percentage point reduction in U.S. GDP. Although China accounts for only 7.4 percent of U.S. exports, indirect spillovers may be much more important.

Anyway, more and more analysts point out the elevated margin debt of investors as the ultimate cause of the market crash. Historically speaking, every time when margin debt rose above 2 percent of the GDP it was usually a signal that a correction was close. This was the case both before the 1929 stock market crash, before the dot-com bubble burst and before the Great Recession. In April this year, the ratio almost approached 3 percent, hitting a new record (yes, the easy money provided generously by central banks has certainly helped to increase margin accounts)… Therefore, the scary headlines from China were only a catalyst which led investors to liquidate their positions.

What does it imply for the U.S. stock market outlook? Well, the market became more reasonably valued, however, total margin debt remains high, which means that we can expect more declines after some rebound. What is crucial here is that with such high margin debt the recent market correction has more parallels with 2001 and 2008 than 1998, contrary to the opinion of Goldman Sachs. This is important because gold reacted more to 2000s stock market crashes than to the 1997/1998 Asian/Russian financial crisis.

To sum up, the reasons behind the last market corrections may be more profound that it is commonly believed. The truth is that the U.S. stocks are overvalued according to various criteria, because ultra-low interest rates led investors to borrow on margin to buy stocks, which in turn helped to keep stock valuations inflated. If history is any indication, the inevitable burst should be positive for the price of gold.

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Arkadiusz Sieron
Sunshine Profits‘ Gold News Monitor and Market Overview Editor

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P.S. Due to a short vacation of the author, the Gold News Monitor will not be released tomorrow.