Wall Street can look vastly different depending on your investment timeline. When examined over multiple decades, we see that stock market corrections are commonplace, but the uptrend in the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) is well-defined.
But things change when that proverbial lens is narrowed. Over shorter periods, directional movements on Wall Street become far less predictable, as evidenced by the three major U.S. stock indexes plunging into a bear market in 2022.
Although new and tenured investors would love for an indicator or metric to predict concretely where stocks are headed next, no such indicator or metric exists. There are, however, select data points that have a knack for accurately predicting the directional movement in stocks more often than not. These indicators and metrics can potentially aid the investors who follow them.
One such financial metric investors often overlook appears to be signaling something big to come for stocks.
The U.S. money supply has come into focus
When investors think about the push-pull of short-term directional movements in stocks, valuation metrics (e.g., price-to-earnings ratio), the yield curve, Federal Reserve monetary policy, and corporate earnings growth are some of the most common factors that come to mind. But what if I told you that the U.S. money supply is the picture that speaks 1,000 words?
Though there are multiple measures of the U.S. money supply, two tend to receive the lion’s share of attention: M1 and M2.
- M1 money supply comprises everything that can effectively be spent right now. We’re talking about cash bills, coins, money in your checking account, and traveler’s checks.
- M2 takes into account everything in M1 and adds money market funds, savings accounts, and certificates of deposit (CDs) of less than $100,000 at financial institutions. You can still spend this money pretty easily, but it’s not as accessible as the capital in M1.
The figure turning heads on Wall Street is the latter, M2.
Historic moves in M2 imply big volatility to come for Wall Street
Dating back more than six decades, M2 has pretty consistently expanded. Between January 1959 ($286.6 billion) and April 2023 ($20.67 trillion), M2 has expanded by an average of more than 3% per year. Since the U.S. economy spends considerable time expanding relative to contracting, having more physical capital available for a growing economy isn’t surprising.
What is surprising is what the M2 money supply has done over the past couple of years.
WARNING: the Money Supply is officially contracting. 📉
This has only happened 4 previous times in last 150 years.
Each time a Depression with double-digit unemployment rates followed. 😬 pic.twitter.com/j3FE532oac
— Nick Gerli (@nickgerli1) March 8, 2023
Between the early part of 2020 and early 2021, the issuance of stimulus checks and other financially supportive programs during the COVID-19 pandemic allowed the M2 money supply to balloon 26% in a single year. Based on back-tested data from the U.S. Census Bureau and Federal Reserve Bank of St. Louis, Reventure Consulting founder and CEO Nick Gerli notes this was the largest expansion of M2 in 153 years.
Although rapidly expanding the U.S. money supply seemed like the right thing to do to support workers who had bills to pay during the pandemic, doing so has had serious consequences. A historic expansion in M2 allowed the inflation rate to surge above 9% in June 2022 — the highest year-over-year increase in over four decades. It also coerced the nation’s central bank to get aggressive with its rate-hiking cycle.
With the Federal Reserve doing everything in its power to cool off the prevailing inflation rate, M2 has now reversed course. For the first time since the Great Depression, the U.S. money supply is contracting.
Since 1870, there have only been five instances where M2 declined by at least 2% on a year-over-year basis. Four of these events occurred between the 1870s and 1933, leading to three depressions and one panic. The fifth instance is ongoing. Since hitting an all-time high of $21.7 trillion in July 2022, M2 has now declined by 4.8%, representing the biggest drop since 1933.
The reason declines in M2 are concerning is twofold. First, a decline in the M2 money supply is typically associated with a higher probability of an economic slowdown. If the inflation rate remains above its historic norm and there are fewer physical dollars and coins in circulation to buy goods and services, we usually see discretionary spending drop off.
History suggests that the worst of the market declines happen during the Recession.
— David Marlin (@Marlin_Capital) April 7, 2023
The other issue is that recessions bode poorly for Wal Street, at least in the very short term. Over the past 95 years, approximately two-thirds of all downside in the benchmark S&P 500 has occurred after, not prior to, a recession being declared.
What’s more, no bear market after World War II has found its bottom prior to an official recession declaration by the eight-economist panel of the National Bureau of Economic Research. That’s one dozen recessionary bear markets all ending after a recession had been declared.
Statistically speaking, if the M2 money supply were to repeat what it did multiple times between 90 and 150 years ago, the U.S. economy would be headed toward a downturn, which would, in all likelihood, weigh on stocks and potentially take the Dow Jones, S&P 500, and Nasdaq Composite to new bear market lows.
Patience is consistently rewarded on Wall Street
While the M2 money supply is doing something truly historic and painting a possibly gloomy picture for investors, it’s important to step back and examine all aspects of this data.
For example, the three depressions and one panic all occurred between the 1870s and 1933. Some of these economic swoons predate the formation of the Federal Reserve in 1913. Though the nation’s central bank may not have all the answers, it does have 110 years of monetary policy under its belt to look back on. In other words, the Fed and federal government are more adept at tackling economic weakness today than a century ago. It means there’s far less likelihood of a serious economic downturn.
Something else to consider is that the previous contractions in M2 didn’t occur after an almost unfathomable one-year expansion of 26% in the money supply. Whereas M2 contractions after modest expansions may have been concerning in the late 19th and early 20th centuries, a return to some form of mean after a 26% expansion in M2 during a single year of the pandemic may not be as ominous as it’s made out to be.
But most importantly, investors should widen their lens. Despite the S&P 500 undergoing a double-digit percentage correction, on average, every 1.88 years since the start of 1950, the benchmark index has had no trouble eventually recouping its temporary losses and marching to new highs.
What’s more, research has shown that buying and holding is a tried-and-true method that builds wealth and helps investors ignore Wall Street’s short-term white noise.
Market analytics company Crestmont Research analyzed what an investor would have, hypothetically, generated in annualized returns if they had purchased an S&P 500 tracking index and held onto that position for 20 years. Crestmont’s team back-tested their rolling 20-year return data to 1900, which led to 104 ending years’ worth of data (from 1919 through 2022). All told, 104 of 104 ending years produced a positive total return, including dividends paid.
Even if this time is the same and the contraction in the M2 money supply does signal an economic downturn and short-term weakness in stocks, the long-term trend in equities points decisively higher.
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