Global Courant
Who needs a theme park when you have Wall Street. For the past two years, we’ve been looking at the timeless Dow Jones Industrial Average (^DJI 0.84%)widely followed by the S&P 500 (^GSPC 1.23%)and growth-dominated Nasdaq Composite (^IXIC 1.45%), roaring to new all-time highs, plunging into a bear market and once again regaining their shine. This short-term rollercoaster ride has both new and regular investors wondering what’s next for Wall Street.
While not an economic data point most investors would look to for advice, the US money supply may provide the answer to what’s next for stocks.
Image source: Getty Images.
M2 money supply hasn’t done this since the Great Depression
While there are a few variations in the money supply, most economists tend to focus on M1 and M2. The first takes into account cash and coins in circulation, as well as demand deposits in checking accounts and traveler’s checks. In other words, money that is either in your hand or very easy to access.
Meanwhile, M2 takes everything in M1 and adds savings accounts, money market funds and certificates of deposit (CDs) below $100,000. It’s money you have access to, but it takes a little extra effort to put this capital to work. It is the M2 money supply that is raising eyebrows on Wall Street and making history.
US M2 money supply data through YCharts.
During the COVID-19 pandemic, M2 rose 26% year-on-year, representing the strongest increase in US money supply when tested back to 1870. The issuance of multiple rounds of stimulus checks to the US public, along with pandemic-based corporate programs pumped capital into the US economy at an extraordinary rate. Unsurprisingly, historically high inflation – 9.1% at its peak in June 2022 – soon followed.
What matters is what happened to the money supply of M2 over the past year. After peaking at $21.7 trillion in July 2022, M2 has fallen to a new value of $20.81 trillion, as of May 2023. While the value in May was higher than in April, breaking a nine-month downward trend, we are still witnessing a 4.1% aggregate decline in M2 from its all-time high.
Given that M2 experienced a historic expansion during the pandemic, it is certainly possible that a 4.1% fall could be dismissed as nothing more than a return of the money supply to the average. But history suggests otherwise.
While history rarely repeats itself on Wall Street, it often rhymes. We have not seen a meaningful annual decline in M2 money supply since the Great Depression in 1933.
WARNING: The money supply is officially shrinking.
This has only happened 4 times before in the last 150 years.
Each time a Depression followed with double-digit unemployment figures. pic.twitter.com/j3FE532oac
–Nick Gerli (@nickgerli1) March 8, 2023
Thanks to a data set provided by Nick Gerli, CEO of Reventure Consulting, we also know that the only four times since 1870 where M2 contracted by at least 2% resulted in deflationary recessions for the US economy. To be completely fair, these events were in the 1870s, 1893, 1921, and the Great Depression. Two of these cases were before the creation of the Federal Reserve, and the nation’s central bank’s understanding of monetary policy has evolved greatly over the past century. There is a good chance that a precipitous depression will not develop in present-day America.
Nevertheless, a declining money supply with above-average inflation is not an ideal combination. If fewer dollars and coins are available to purchase goods and services, the expected response is that consumers and businesses will buy less. Historically, that’s a recipe for recession — and recessions can lead to significant downside in the Dow Jones, S&P 500, and Nasdaq Composite.
Money could be the thorn in the side of Wall Street’s rally in the first half
The point of a declining M2 is that it is far from the only money-based economic data point or indicator that signals trouble. While Wall Street largely shrugged off these concerns thanks to a major rally in the first half of branded, mega-cap growth stocks, money could eventually become a thorn in Wall Street’s side.
US Commercial Banks Bank Credit data through YCharts.
For example, look no further than US commercial bank credit. For 50 years, credit from commercial banks has increased significantly, to the point that few economists bother to look at the benchmark on a regular basis. This is not surprising given that the US economy has been growing for long periods of time and banks are looking to borrow money to cover the costs associated with taking deposits.
While there have been peaks over the past 50 years where commercial bank lending in the US declined by a few tenths of a percent, there are only four instances where commercial bank lending declined by 1.5% or more. In three of those incidents (1975, 2001 and 2009-2010), the benchmark S&P 500 fell by about 50%. The fourth is underway, with US commercial bank lending down 1.75% from its peak in March 2023.
What this weekly reported data point tells us is that banks are tightening their credit standards. Whatever the specific reason for banks to adjust their credit terms, the main point is that it is becoming increasingly difficult (and more expensive with higher interest rates) to raise capital. Again, that’s a formula for slower economic growth, if not a recession.
Net percentage of US banks report tightening standards for C&I lending to large and medium-sized companies data through YCharts. Gray areas indicate US recessions.
In addition, we also see clear signs of reluctance among banks when it comes to commercial and industrial (C&I) lending to large and medium-sized companies. C&I loans are usually short-term and provide working capital to companies so they can finance a major project or an acquisition. As with commercial bank lending, long-term C&I lending has been steadily rising as banks look to reap the rewards of the US economy and spend much more time growing than shrinking.
Each quarter, the Board of Governors of the Federal Reserve System reports the net percentage of domestic banks tightening credit terms for C&I loans to large and medium-sized companies. The Q2 2023 update found that 46% of domestic banks are making it harder to get a C&I loan. Although there has been much more credit tightening since 1990, this figure of 46% is right around the level at which previous recessions in the US were declared.
Image source: Getty Images.
Wall Street is a numbers game that greatly favors the patient
Based on what we see from M2 money supply, commercial bank lending and domestic banks tightening their credit standards for C&I lending, the makings of a US recession are definitely in place. Stock losses have historically been most pronounced in the months following the official declaration of a recession by the National Bureau of Economic Research’s panel of eight economists.
However, Wall Street’s performance largely depends on your investment period. If you’re patient, these and other potentially worrying money statistics represent nothing more than temporary white noise.
For example, did you know that the S&P 500 has averaged a double-digit correction every 1.88 years since the early 1950s? Double-digit declines, as much as we as investors may not like them, are a normal part of the investment cycle.
It is official. A new bull market is confirmed.
The S&P 500 is now up 20% from its 10/12/22 low. During the previous bear market, the index fell 25.4% in 282 days.
Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
— Custom (@bespokeinvest) June 8, 2023
At the same time, it is also something that bull markets last longer than bear markets. According to calculations by asset management firm Bespoke Investment Group, the 27 bear markets — defined as a 20% drop from recent highs after a rally of at least 20% — that the S&P 500 has been experiencing since 1929 have averaged 286 calendar days, or about 9.5 month. By comparison, the 27 bull markets over the same period averaged 1,011 calendar days, or about two years and nine months. Bull markets last on average 3.5 times longer than bear markets.
You can also clearly see the power of time on long-term charts of every major US stock index. Take the Dow Jones Industrial Average as a perfect example. It lost nearly 90% of its value during the Great Depression and has weathered a number of slumps of about 50 percentage points since its inception in 1896. Despite all the myriad concerns about the US economy and the state of stocks, the long-term Dow has continued to climb to new all-time highs.
While we never know exactly when stock market declines will occur, how long they will last, or how much the market will ultimately fall, history conclusively shows that major indices eventually push their way to new highs. Being patient and letting the numbers game work in your favor is a wealth creation formula that is unparalleled on Wall Street.
