Over lengthy periods, it’s tough to outpace equities in the return column. Compared to gold, oil, housing, and Treasury bonds, the annualized return of stocks trumps them all over the long run.
However, the predictability of directional moves in the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) gets thrown out the window when the time frame is narrowed. Since the start of 2020, these three indexes have traded off bear and bull markets in successive years.
Even though forecasting directional moves for the major indexes can’t be done with 100% accuracy, it doesn’t stop investors from trying to gain an edge. This is where a very select group of economic data points and predictive indicators comes into play. Though Wall Street offers no short-term guarantees, a couple of data points and indicators do have exceptional track records of correlating with moves higher or lower in the broader market.
One such data point that speaks volumes at the moment is U.S. money supply.
Among the five money supply measures, two receive the bulk of the attention from economists and investors: M1 and M2. M1 factors in all the cash and coins in circulation, as well as demand deposits in a checking account. Think of M1 as cash that’s easily accessible and can be spent in the blink of an eye.
Meanwhile, M2 takes into account everything in M1 and adds in savings accounts, money market accounts, and certificates of deposit (CDs) below $100,000. M2 is still factoring in cash that consumers can spend, but it’s adding in capital that takes a bit more effort to get to. It’s this figure, M2, that is causing alarm in the investing world.
For well over a century, U.S. money supply has been rising with little interruption. Since a growing economy requires more cash and coins in circulation to complete transactions, rising money supply is something economists and investors tend to take for granted and assume is a given.
But on rare occasions, U.S. money supply contracts in a big way — and that’s historically portended bad news for the U.S. economy and stock market.
In July 2022, U.S. M2 money supply peaked at an all-time high of roughly $21.7 trillion. Based on the Feb. 27 data release from the Board of Governors of the Federal Reserve, M2 stood at $20.78 trillion, as of January 2024. All told, we’re looking at a year-over-year drop of 1.44% and an aggregate decline from the July 2022 peak of 4.21%. This is the first significant drop in M2 since the Great Depression.
The caveat to the decline since July 2022 is that M2 expanded at a truly historic pace during the COVID-19 pandemic. Fiscal stimulus increased M2 by a record 26% on a year-over-year basis. Thus, a case could be made that a 4.21% retracement is merely a reversion to the mean. Then again, history has been incredibly unforgiving when M2 money supply has fallen by at least 2% on a year-over-year basis.
According to research conducted by Reventure Consulting CEO Nick Gerli, which relied on data from the U.S. Census Bureau and the Federal Reserve, there have only been five instances, when back-tested to 1870, where M2 has declined by at least 2%: 1878, 1893, 1921, 1931-1933, and July 2022 through at least January 2024. The previous four instances all coincided with deflationary depressions and double-digit unemployment rates.
If I can offer a ray of hope, two of the four previous incidences occurred prior to the creation of the nation’s central bank, and the other two date back more than nine decades. The Federal Reserve’s knowledge of monetary policy, and the fiscal tools available to the federal government, make it highly unlikely that a depression would materialize today.
On the flip side, declining money supply isn’t something that should be swept under the rug. If the core inflation rate remains above the Fed’s 2% long-term target and M2 continues to decline, there will be less discretionary income to go around.
Based on data from Bank of America Global Research, about two-thirds of the S&P 500’s max drawdowns occur after, not prior to, a U.S. recession being declared. In short, a persistent decline in M2 money supply could spell trouble for a currently red-hot stock market.
The worry for investors is that M2 represents just one money metric that looks to be working against the U.S. economy and stocks, as a whole. Another key money-based data point that’s cause for concern is commercial bank credit.
Commercial bank credit is reported by the Board of Governors of the Federal Reserve on a weekly basis and factors in all of the loans, leases, and securities held by U.S. commercial banks. Over the past 51 years, commercial bank credit has expanded from around $567 billion to roughly $17.44 trillion, as of the week ended Feb. 14, 2024.
Just as M2 rising over time makes complete sense, so does the regular expansion of commercial bank credit. As the U.S. economy grows, it’s only natural that consumers and businesses are going to increase their borrowing. Furthermore, commercial banks offset the cost of taking in deposits by lending.
Trouble arises when this steadily climbing metric heads decisively south.
Since data reporting began in January 1973, there have only been three instances where commercial bank credit has pulled back at least 2% from its all-time high:
In October 2001, during the dot-com bubble, commercial bank credit slipped a maximum of 2.09%.
In March 2010, shortly after the Great Recession, commercial bank credit troughed at a 6.94% decline.
In November 2023, commercial bank credit hit a peak drop of 2.07%.
While it is worth noting that commercial bank credit has begun climbing in recent weeks, the drop throughout 2023 pretty clearly shows that banks have tightened their lending standards. When lending institutions become pickier about how they lend their money, it’s not uncommon for businesses to pare back hiring, innovation, and acquisitions. Put another way, a notable decline in commercial bank credit can be a precursor to an economic downturn.
Although Wall Street and the economy aren’t intertwined, recessions tend to negatively impact corporate earnings, which in turn would be expected to send the Dow Jones, S&P 500, and Nasdaq Composite lower. For context, the S&P 500 lost around half of its value during the previous two sizable contractions in commercial bank credit.
Considering that the Dow Jones Industrial Average and S&P 500 have rocketed to record-closing highs in 2024, a prognostication of downside in the broader market probably isn’t what you want to hear. But just as history can, at times, serve as a short-term guide that portends downside in stocks, it’s often the greatest ally of patient investors.
As much as workers and investors might dislike recessions, the fact remains that they’re a normal and unavoidable part of the economic cycle. They’re also notoriously short-lived. Only three recessions of the 12 that have occurred since the end of World War II made it to the 12-month mark, and none of the remaining three lasted longer than 18 months. In other words, downturns in the U.S. economy are fleeting.
Compare this to periods of growth over the past 78 years and change. Though there are a couple of growth spurts that lasted around a year, most expansions were multiyear events. In fact, two periods of growth surpassed the 10-year mark.
This disparity between U.S. economic growth and contractions is seen in Wall Street’s major indexes. As an example, the S&P 500 has endured 40 separate double-digit percentage corrections since the start of 1950. However, each and every one of these downturns was eventually put in the back seat by a bull market rally. Despite never knowing precisely when these declines will occur, history has pretty conclusively shown that the major indexes will rise in value over time.
It’s official. A new bull market is confirmed.The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
— Bespoke (@bespokeinvest) June 8, 2023
To add to the above, the analysts at Bespoke Investment Group put out a dataset in June 2023 that compared the average length of bear markets in the benchmark S&P 500 to bull markets since the start of the Great Depression in September 1929. While the average bull market has endured 1,011 calendar days, the 27 bear markets over the past 94 years have stuck around for an average of only 286 calendar days (about 9.5 months).
The final data set that overwhelmingly demonstrates the power of time and perspective for investors is updated annually by Crestmont Research.
The researchers at Crestmont analyzed the rolling 20-year total returns, including dividends, of the S&P 500 dating back to 1900. Even though the S&P didn’t come into existence until 1923, researchers were able to trace its components to other major indexes at the time, thereby allowing total returns data to be back-tested to the start of the 20th century. This left Crestmont with 105 rolling 20-year periods (1919-2023) to analyze.
What Crestmont’s dataset showed is that all 105 rolling 20-year periods produced a positive total return. Hypothetically speaking, as long as an investor purchased an S&P 500 tracking index since 1900 and held that position for 20 years, they made money, without fail, every time.
No matter what M2 money supply and commercial bank credit suggest will happen with stocks, long-term investors are perfectly positioned to succeed.
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Bank of America is an advertising partner of The Ascent, a Motley Fool company. Sean Williams has positions in Bank of America. The Motley Fool has positions in and recommends Bank of America. The Motley Fool has a disclosure policy.
U.S. Money Supply Is Making History for the First Time Since the Great Depression, and It Implies a Big Move in Stocks Is on the Way was originally published by The Motley Fool
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