How rising leverage and stock market vulnerabilities could shape the next big downturn
The stock market may look stable on the surface, but beneath lies a mounting wave of financial leverage unseen since 1929. In this article, we break down what this means for investors today, how an economic downturn might impact market earnings and valuations, and what to watch for as risks build up. If you’re serious about smart crypto and stock investing, understanding leverage’s role is key to planning ahead.
How Leverage Today Compares to the 1929 Crash
Back in 1929, margin debt—the loans investors take to buy stocks—peaked at about $10 billion, roughly 9% of the U.S. GDP. This was a massive leverage buildup that fueled the infamous market crash.
Fast forward to 2025, margin debt has soared to almost $1.1 trillion. At first glance, that’s just 3.5% of GDP—lower than 1929. But this doesn’t tell the whole story.
When you add $135 billion in leveraged Exchange-Traded Funds (ETFs) and a staggering $5 trillion in equity-linked derivatives like options, contracts for difference (CFDs), and swaps, the total leverage exposure balloons to about 20% of U.S. GDP. That’s more than double the 1929 peak.
What Is Margin Debt and Leveraged ETFs?
- Margin debt: Borrowing money to buy stocks, amplifying gains, but also losses.
- Leveraged ETFs: Funds using financial derivatives to multiply investment returns—can spike risk quickly.
The Calm Before the Storm: 15 Years of Steady Growth
Since 2009’s financial crisis, the U.S. economy has enjoyed relative stability with steady growth in earnings and stock prices. This stable macroeconomic backdrop has encouraged investors to take on more leverage without immediate consequences.
However, history warns us this calm doesn’t last forever. When confidence drops and earnings decline, highly leveraged markets can amplify losses rapidly.
What Happens When Earnings Take a Hit?
The U.S. stock market’s value hinges on two main factors:
- Earnings per share (EPS) of companies.
- The Price-to-Earnings (PE) ratio investors are willing to pay.
As of now, the S&P 500 reports EPS around $294 and a PE ratio of 22.8, pushing the index roughly to 6,730 points.
Why Consumer Spending Matters
Half of U.S. consumer spending comes from the top 10% income earners. This is the highest proportion since the 1990s, supported by strong stock prices.
Since 1990, household exposure to stocks has jumped from 5% to 40% of their assets, making many Americans feel wealthier and spend more—fueling earnings growth.
The Wealth Effect Explained
- Wealth effect: Rising stock markets make people feel richer, boosting spending and economic growth.
- Inverse wealth effect: Falling markets make people cut back, dragging down the economy and corporate earnings.
Because household wealth is so tied to stocks now, a market slump could cause consumer spending—and earnings—to fall more sharply than in past recessions.
Modeling a Possible Market Downturn
Historically, recessions have caused about a 30% drop in earnings. Given today’s leverage and dependence on top-income consumer spending, this loss could swell to 40%.
- EPS could fall from $294 to about $206.
- If PE ratios stayed the same, the S&P 500 would drop roughly 40% to 4,692 points.
But PE ratios rarely hold steady during recessions. Since the 2008 financial crisis, valuations have been high, partly due to leverage inflating stock prices.
During recessions, PE ratios tend to contract an average of 30%, sometimes more.
- A 40% PE contraction could take the ratio from 22.8 down to ~13.5.
- Combining this with the EPS drop means the S&P 500 could plunge approximately 64% to around 2,818 points.
- This level is near the lows seen during the COVID-19 crash in 2020. ---
Data Callout: Leverage in Financial Markets (as % of U.S. GDP)
| Leverage Type | Approximate Amount | % of GDP |
|---|---|---|
| Margin Debt | $1.1 Trillion | 3.5% |
| Leveraged ETFs | $135 Billion | 0.4% |
| Equity-linked Derivatives | $5 Trillion | 16% |
| Total Leverage Exposure | ~$6.25 Trillion | ~20% |
This data highlights how leveraged products have exploded beyond traditional margin debt, creating systemic risk.
Risks / What Could Go Wrong?
- Market panic: A sudden loss in investor confidence could rapidly unwind leverage, accelerating price drops.
- Economic shock: Inflation shocks, geopolitical events, or a sharp rise in interest rates could trigger a recession.
- Policy response: Central bank actions may not prevent collapses if leverage magnifies selling pressure.
- Personal finance impact: Rising stock exposure among average households means falling markets hurt consumer spending, creating a feedback loop.
Investors ignoring these risks risk being unprepared for tumultuous conditions.
Actionable Summary
- Market leverage is at levels twice that of the 1929 crash when combining margin debt and derivatives.
- High household exposure to stocks intensifies the wealth effect, making earnings vulnerable in downturns.
- Historical recessions result in 30-40% earnings drops; combined with PE ratio contractions, stocks could drop 60%+.
- Planning for leverage unwind scenarios is crucial—don’t dismiss the risks just because markets feel stable.
- Stay informed, diversified, and have risk management rules ready.
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Answer Box: What Is the Current Level of Leverage in the US Stock Market Compared to 1929?
Today’s total market leverage—including margin debt, leveraged ETFs, and equity-linked derivatives—equals about 20% of U.S. GDP. This is more than double the peak leverage level seen in 1929, when margin debt alone was 9% of GDP. The expanded use of derivatives has vastly increased systemic risk beyond traditional borrowing.
FAQ
Q1: What is margin debt and why does it matter?
A1: Margin debt is borrowing money to buy stocks, amplifying your buying power. It matters because high margin debt can increase losses and trigger forced selling during market declines, worsening crashes.
Q2: How does the wealth effect impact the economy?
A2: When stock prices rise, people feel richer and spend more, boosting economic growth. When markets fall, the inverse wealth effect causes reduced spending, hurting earnings and growth.
Q3: Could the S&P 500 really drop 60%?
A3: It’s possible if earnings decline sharply and PE ratios contract during a recession fueled by deleveraging. History shows recessions often cause significant market pullbacks.
Q4: What should investors do to prepare?
A4: Diversify, manage risk, avoid excessive leverage, and consider protecting portfolios with hedges or safer assets. Staying informed and having a plan is essential.
Q5: Are leveraged ETFs safe for long-term investment?
A5: Leveraged ETFs are typically meant for short-term trading. They involve compounding and can be riskier in volatile markets, not a buy-and-hold tool for most investors.
Disclaimer: This article is for informational purposes and does not constitute financial advice. Markets carry risk. Do your own research and consider consulting a certified financial advisor before making investment decisions.
By Wolfy Wealth - Empowering crypto investors since 2016
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