Over the long run, Wall Street is a money machine for patient investors. But when examined over a period of months or perhaps a year or two, the stock market can truly be “a riddle wrapped in a mystery inside an enigma,” to quote the late Winston Churchill.
Over the trailing two years, the iconic Dow Jones Industrial Average (^DJI -0.43%), broad-based S&P 500 (^GSPC -0.53%), and growth-focused Nasdaq Composite (^IXIC -0.36%), surged to all-time closing highs, plummeted into a bear market, and have now rocketed out of the gate in 2023 into what some investors would deem is a new bull market.
Image source: Getty Images.
When Wall Street gets whipsawed, investors often turn to an assortment of economic datapoints, probability tools, and other metrics to offer clues as to which direction stocks will head next. Although there is no such thing as a foolproof datapoint, tool, or metric — if there were, everyone would be using it by now — there are a number strong historic correlations that have the potential to aid investors who follow specific datasets or indicators.
One such economic datapoint, which has been making history over the past couple of years, suggests a big move may be upcoming for the Dow Jones, S&P 500, and Nasdaq Composite.
U.S. money supply is making history — but potentially not in a good way
While there is no shortage of economic datapoints to choose from, it doesn’t get any more organic than literally following the money. More specifically, I’m talking about U.S. money supply.
The most widely followed money supply datapoints are M1 and M2. The former takes into account cash and coins in circulation, along with demand deposits in checking accounts. In other words, it’s money you can spend at a moment’s notice. Meanwhile, M2 encompasses everything in M1 and adds money market accounts, savings accounts, and certificates of deposit (CDs) below $100,000. This is money you can get to, but it takes extra effort.
When examined with a wide lens, M2 has been steadily increasing for more than 150 years, based on back-tested data provided by Reventure Consulting CEO Nick Gerli. However, we’ve seen M2 make two historic moves over the past couple of years that should leave investors cautious.
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)
To start with, M2 money supply expanded by 26% on a year-over-year basis during the COVID-19 pandemic, which represented the biggest year-over-year jump in history. Multiple rounds of stimulus payouts pumped cash into the U.S. economy at a torrid pace and rapidly expanded M2 (along with the U.S. inflation rate).
But what’s even more telltale is what’s now happening with M2 money supply. Since peaking at roughly $21.7 trillion in July 2022, M2 has declined to about $20.89 trillion, as of June 2023. For those of you without a calculator, we’re talking about a 3.75% drop from the all-time high.
Nominally, a 3.75% decline in U.S. M2 money supply doesn’t sound all that bad, especially after a 26% year-over-year expansion in a single year during the COVID-19 pandemic. It’s always possible this decline represents nothing more than a reversion to the mean, so to speak.
Yet there’s another side to this story. The 3.75% drop in M2 represents the first meaningful contraction of U.S. money supply since the Great Depression in 1933. In fact, it’s only the fifth time in history we’ve witnessed a drop in M2 of at least 2% on a year-over-year basis. The other four times M2 fell by at least 2% resulted in three depression (1870s, 1921, and the Great Depression) and one panic (1893).
To be completely objective, these four events happened a long time ago. The Federal Reserve didn’t even exist during the Depression of the 1870s or Panic of 1893. With roughly 110 years of monetary policy know-how now under its belt, and the federal government ready to act with fiscal initiatives, if necessary, the likelihood of a depression in today’s economy is quite low.
Nevertheless, history has been unkind when U.S. money supply is declining. If this contraction in M2 does signal a coming recession, it could be an ominous warning for stocks that meaningful downside awaits.
The money trail leads to other potential concerns
What makes the drop in M2 so concerning is that it’s just one of numerous money-centric datapoints that implies weakness to come for the U.S. economy and/or Wall Street. As a reminder, stocks have historically performed poorly following the initial declaration of a recession by the eight-economist panel of the National Bureau of Economic Research.
For instance, commercial bank lending is teetering in dangerous territory, by historic standards.
Generally speaking, banks are eager to lend money to generate net-interest income that’ll more than offset the various costs and liabilities associated with taking in deposits. Over the past half-century, there’s been a relatively uninterrupted increase in total commercial bank credit.
US Commercial Banks Bank Credit data by YCharts.
However, things changed earlier this year. The short-lived regional banking crisis that saw three prominent banks get seized by regulators — SVB Financial‘s Silicon Valley Bank, Signature Bank, and First Republic Bank — coerced banks to tighten their lending standards. As of July 19, 2023, commercial bank credit was 1.63% below the all-time high of $17.59 trillion on February 15.
Once again, a 1.63% drop doesn’t nominally sound like much. But over a 50-year period, it marks only the fourth such instance where bank lending has dropped by at least 1.5%. The three previous occurrences all saw the benchmark S&P 500 lose around half of its value.
Beyond commercial bank lending, we’re witnessing a historic drop in the net percentage of domestic banks reporting inquiries for commercial and industrial (C&I) loans, as well as a significant uptick in U.S. banks that are making it harder to get a credit card loan.
When banks begin to paring back their willingness to lend, it chokes off a fuel source for growth companies that use borrowed capital to hire, acquire, and innovate. In short, it’s a pretty clear sign that banks either see trouble on the horizon, or are already dealing with negative economic repercussions.
Image source: Getty Images.
Following the money over the long run is a surefire investment strategy
Based on what following the money tells us, the U.S. economy, and therefore stock market, could be in for a rough stretch in the months and quarters to come. Based solely on historic correlation, a double-digit percentage decline in the Dow, S&P 500, and Nasdaq Composite may be in play.
But following the money leads to a very different conclusion if your investing horizon looks out many years, if not decades.
For example, optimistic investors should disproportionately benefit over the long run. Whereas the 12 U.S. recessions after World War II have lasted just two to 18 months, the typical economic expansion usually goes on for years. A naturally expansive gross domestic product pulls corporate earnings higher over time, which allows the Dow, S&P 500, and Nasdaq Composite to also charge higher over long periods.
This disproportionate benefit of being an optimist can be seen in the average length of bull and bear markets, too.
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)
According to data compiled by wealth management company Bespoke Investment Group, there have been 27 separate bull and bear markets since September 1929. The average bear market has lasted just 286 calendar days, which equates to less than 10 months. By comparison, the average bull market since the Great Depression has trudged along for 1,011 calendar days, or about two years and nine months. Put another way, the typical bull market lasts around 3.5 times longer than the average bear market.
Statistically speaking, being a long-term optimist gives investors the highest probability of building wealth on Wall Street. Although getting from point A to B won’t be without it many short-term challenges, patience and following the money over the long run is a virtually undefeated moneymaking strategy.
This content was originally published here.
