The US money supply is making history for the first time since the Great Depression, and it means a big move in stocks is on the way

Over long periods, it's difficult to outperform stocks in the return column. Compared to gold, oil, housing, and treasury bonds, the annual return of stocks is superior to them in all cases in the long term.

However, the predictability of directional movements in… Dow Jones Industrial Average (^ DJI 0.23%), Standard & Poor's 500 (^GSBC 0.80%)And Nasdaq Composite (^ xix 1.14%) They are thrown out the window when the time frame is narrowed. Since the start of 2020, these three indices have traded away from bear and bull markets in consecutive years.

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Although predicting the trend movements of major indices cannot be done with 100% accuracy, that does not stop investors from trying to gain an edge. This is where a very select set of economic data points and predictive indicators come into play. Although Wall Street offers no short-term guarantees, certain data points and indicators have exceptional track records of correlation with higher or lower moves in the broader market.

One data point that is talking a lot right now is the US money supply.

The US money supply has not done this since 1933

Of the five money supply measures, two receive the most attention from economists and investors: M1 and M2. M1 takes into account all cash and coins in circulation, as well as demand deposits in the current account. Think of M1 as easily accessible cash that can be spent in the blink of an eye.

Meanwhile, the M2 takes into account everything in the M1 and adds savings accounts, money market accounts, and certificates of deposit (CDs) under $100,000. M2 still takes into account the cash consumers can spend, but adds capital that requires more effort to access. It is this number, M2, that is causing concern in the investment world.

For more than a century, the money supply in the United States has been rising without interruption. Since a growing economy requires more money and coins in circulation to complete transactions, a rising money supply is something economists and investors tend to take for granted and assume.

But on rare occasions, US money supply contracts are overextended – and this historically bodes bad news for the US economy and stock market.

US money supply chart M2

US money supply M2 Data by YCharts.

In July 2022, the US M2 money supply peaked at an all-time high of approximately $21.7 trillion. Based on Federal Reserve Board of Governors data released on February 27, M2 stands at $20.78 trillion, as of January 2024. In total, we are looking at a 1.44% year-over-year decline of 1.44% and a total decline from the July 2022 peak of 4.21%. This is the first significant decline in M2 since the Great Depression.

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The caveat to the decline since July 2022 is that the M2 has expanded at a truly historic pace during the COVID-19 pandemic. Fiscal stimulus increased M2 by a record 26% year-on-year. Therefore, it can be said that the 4.21% retracement is just a reversion to the mean. But then again, history has been incredibly cruel when the M2 money supply has fallen by at least 2% on an annual basis.

According to research by Reventure Consulting CEO Nick Gurley, which relied on data from the US Census Bureau and the Federal Reserve, there were only five instances, when backtested through 1870, in which M2 fell by at least 2%: 1878, 1893, 1921, 1931-1933, and July 2022 until at least January 2024. The previous four cases coincided with periods of deflationary depression and double-digit unemployment rates.

If I can offer a glimmer of hope, two of the previous four incidents occurred before the establishment of the country's central bank, while the other two dates back more than nine decades. The Fed's knowledge of monetary policy, and the financial tools available to the federal government, make it highly unlikely that a depression would materialize today.

On the other hand, a decline in the money supply is not something that should be overlooked. If core inflation remains above the Fed's long-term target of 2% and the money supply (M2) continues to decline, discretionary income will be lower.

Based on data from American bank Global Research, about two-thirds of the S&P 500's maximum drawdowns occur after, rather than before, a recession is announced in the United States. In short, a continued decline in the M2 money supply could cause problems in the currently hot stock market.

Keeping track of money has been an issue this past year

What worries investors is that the M2 represents only one monetary measure that appears to be working against the US economy and stocks as a whole. The other major money-based data point that is causing concern is commercial bank credit.

Commercial bank credit is reported by the Federal Reserve Board of Governors on a weekly basis, taking into account all loans, leases, and securities held by U.S. commercial banks. Over the past 51 years, commercial bank credit has expanded from approximately $567 billion to approximately $17.44 trillion, as of the week ending February 14, 2024.

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Just as a rise in M2 over time makes perfect sense, so does a systematic expansion of commercial bank credit. As the US economy grows, it is natural for consumers and businesses to borrow more. Moreover, commercial banks offset the cost of accepting deposits by lending.

The problem arises when this rising scale heads steadily south.

Bank credit chart of US commercial banks

American commercial banks bank credit Data by YCharts.

Since data reporting began in January 1973, there have been only three instances in which commercial bank credit has fallen at least 2% from its all-time high:

  • In October 2001, during the dot-com bubble, commercial bank credit fell by a maximum of 2.09%.
  • In March 2010, shortly after the Great Recession, commercial bank credit fell by 6.94%.
  • In November 2023, commercial bank credit reached a peak decline of 2.07%.

While it is worth noting that commercial bank credit has begun to rise in recent weeks, the decline throughout 2023 clearly shows that banks have tightened their lending standards. As lending institutions become more selective about how they lend their money, it is not uncommon for companies to cut back on hiring, innovation, and acquisitions. In other words, a marked decline in commercial bank credit could be a precursor to an economic downturn.

Although Wall Street and the economy are not intertwined, recessions tend to negatively impact corporate profits, which in turn are expected to drag down the Dow Jones, S&P 500, and Nasdaq Composite. In this context, the Standard & Poor's 500 index lost about half its value during the previous two major contractions in commercial bank credit.

Sitting person reading a financial newspaper while holding a tablet in his left hand.

Image source: Getty Images.

History is actually the best friend of long-term investors

Given that the Dow Jones Industrial Average and S&P 500 have both rallied to record closing levels in 2024, speculating about the downside in the broader market is probably not what you want to hear. But just as history can, sometimes, serve as a short-term guide to downside in stocks, it is often the greatest ally of patient investors.

As much as workers and investors may hate recessions, the fact remains that they are a natural and unavoidable part of the economic cycle. It is also short-lived. Only three of the twelve recessions that have occurred since the end of World War II have been able to reach the 12-month mark, and none of the remaining three have lasted longer than 18 months. In other words, recessions in the US economy are fleeting.

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Compare this to periods of growth over the past 78 years and change. Although there have been growth spurts that last approximately one year, most expansions have been multi-year events. In fact, two periods of growth exceeded the ten-year mark.

This disparity between economic growth and contraction in the United States is visible in the main indicators on Wall Street. For example, the S&P 500 has suffered 40 separate double-digit percentage corrections since the beginning of 1950. However, each of these downturns was eventually put on the backseat by a bull market rally. Although it is not known exactly when these declines will occur, history has shown conclusively that major indices will rise in value over time.

To add to the above, analysts at Bespoke Investment Group put out a data set in June 2023 comparing the average length of bear markets in the benchmark S&P 500 index to bull markets since the start of the Great Depression in September 1929. While the average length of bull markets has… The market endured for 1,011 calendar days, while the 27 bear markets over the past 94 years stuck around for an average of only 286 calendar days (about 9.5 months).

The definitive data set that dramatically illustrates the power of time and perspective for investors is updated annually by Crestmont Research.

Researchers at Crestmont analyzed the 20-year rolling total returns, including dividends, of the Standard & Poor's 500 index dating back to 1900. Although the S&P did not come into existence until 1923, the researchers were able It traces its components to other major indicators in time, allowing backtesting of total returns data to the beginning of the twentieth century. This left Crestmont with 105 20-year time periods (1919-2023) to analyse.

What the Crestmont data set showed was that all 105 periods spanning 20 years produced a positive total return. In theory, as long as an investor buys the S&P 500 tracking index since 1900 and holds that position for 20 years, he or she has made money without fail. all time.

Regardless of what the M2 money supply and merchant bank credit indicate will happen with stocks, long-term investors are perfectly positioned for success.

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