Aggregate Margin Debt and the Divergence of Price from Accounting Fundamentals

Abstract

We examine whether, in the aggregate, margin debt is associated with the divergence of price from accounting fundamentals. We find that investors increase their margin debt following upward price movements away from accounting fundamentals, consistent with these investors being extrapolative in aggregate. We also find evidence that margin debt appears to be linked to temporary overpricing in recent periods, as the aggregate ratio of margin debt-to- price is reliably associated with negative future returns since at least 1992. Our results are consistent with the theoretical literature which predicts extrapolative traders provide a destabilizing effect on market prices and help explain why prices diverge from accounting fundamentals.