The Breathtaking Rally could be Running Out of Steam

Yes, we’ve seen this movie before and it ends badly.

Not only has the little-guy investor joined the stock party, but they are doing so with gusto and borrowing money to do it, lured by the prospect of Dow 20,000.

As with past bubbles, investors are borrowing on margin at a record clip, with aggregate margin borrowing recently hitting $380 billion, the highest level since July 2007.

“Emboldened by soaring stock prices and record-low borrowing costs, stock investors are taking out loans against their portfolios at the fastest pace since before the Great Recession,” wrote Adam Shell in USA Today earlier this month.

After suffering through the stock market bloodbath of 2008 and 2009, investors borrowing on margin indicates the investing public is feeling good again about stocks. Broad stock market indexes through the end of Wednesday were up more than 16% for the year. Why not pile into stocks?

Well, there are a couple of indicators that the breathtaking rally could be running out of steam.

“”There’s also a dark side,” Shell wrote. “The use of borrowed money could be signaling that risk-taking is becoming more extreme and that investor enthusiasm is becoming too bullish, which could set those investors and market up for disappointment if stocks turn south.”

Meanwhile, tepid profit reports haven’t dented stock market rally, either. With the US economy stalled in a slow-growth mode, stock prices cannot go up forever, noted Alexandra Scaggs last week in the Wall Street Journal. “Stock-rally skeptics said that spells trouble,” Scaggs wrote.

This is reminiscent of the housing bubble and crash where home-equity borrowing soared only to later see homeowners saddled with debt and crushed by falling home prices.

You can bet stockbrokers are dutifully changing investor-risk-profile paperwork at their firms so when the crash comes they can point the finger at their customers, in an effort to absolve themselves of responsibility despite having convinced those customers to go “all in.”

Indeed, a recent survey of financial advisers reveals that advisors and their clients commonly don’t understand each other at all when it comes to measuring risk tolerance, noted Wall Street Journal columnist Jason Zweig earlier this month.

The survey of 5,000 financial advisors found that advisers believed 26% of clients had an “aggressive” tolerance for risk, while a parallel survey of clients found that only 8% regarded themselves as “aggressive.”

This is what investors face: soft economic growth, weak revenues, the Dow up 16% for the year and financial advisors pushing clients to take increased risk. Those are the key ingredients of a bubble. Investors shouldn’t be surprised when it pops.