Whether you realize it or not, stock market corrections, crashes, and bear markets are normal parts of investing. Since the beginning of 1950, the benchmark S&P 500 (^GSPC -0.38%) has undergone 39 separate double-digit percentage declines, according to data provided by sell-side consultancy company Yardeni Research.
Last year marked the most recent of these 39 notable moves lower. The ageless Dow Jones Industrial Average (^DJI -0.51%), broad-based S&P 500, and growth-dependent Nasdaq Composite (^IXIC -0.29%) all fell into a bear market and closed out 2022 with respective losses of 9%, 19%, and 33%. These represent the worst returns for all three major U.S. indexes since 2008.
But if one leading economic indicator has anything to say about it, the worst is yet to come for Wall Street.
Image source: Getty Images.
A major warning is sounding on Wall Street for only the fifth time since 1870
Before digging in, let's state the obvious: There is no 100%, for-sure, concrete indicator that will accurately predict when bear markets or crashes will occur, how long they'll last, or how steep their declines will be.
However, there are indicators that, over long stretches of history, have provided flawless or near-flawless prognostications when it comes to either forecasting a recession or predicting where the stock market will head next. The U.S. money supply is one such leading economic indicator with an extensive track record of success within certain parameters.
The two commonly tracked money supply metrics are known as M1 and M2. M1 takes into account the amount of cash bills and coins currently in circulation, as well as traveler's checks. In other words, M1 is money in your pocket or at your immediate disposal. M2 accounts for everything in M1 but adds savings accounts, certificates of deposit (CD) below $100,000 at the bank, and money market funds. This is money you have pretty quick access to, but you need to do a bit more work to get it.
The blaring warning being sounded to Wall Street relates to M2, and it comes courtesy of data presented on social media platform Twitter by the CEO and founder of Reventure Consulting, Nick Gerli.
Using historic M2 and U.S. inflation rate data from the Federal Reserve Bank of St. Louis and the U.S. Census Bureau, Gerli plotted out how the money supply and inflationary/deflationary pressures can sometimes correlate.
WARNING: the Money Supply is officially contracting. 📉
-- Nick Gerli (@nickgerli1) March 8, 2023
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
As you can see from Gerli's chart above, there have been only five instances since 1870 when the U.S. money supply (M2) declined at least 2% on a year-over-year basis. Of the previous four occurrences, three economic depressions and one panic followed, along with double-digit unemployment rates in each case. The fifth such decline of at least 2% in M2 over the past 153 years is occurring right now.
The issue at hand is what even a small decline in money supply can do to an economy with relatively high inflation, such as the U.S. is experiencing right now. If there's less money in circulation as prices climb, something eventually breaks. The expectation would be for an abrupt slowing in buying activity and across-the-board weakness in pricing power, including energy commodities, such as oil and natural gas.
Since the stock market doesn't necessarily trade in lockstep with the U.S. economy, you might be wondering why a decline in M2 is a concern for Wall Street. The answer is simple: Since World War II, the stock market hasn't reached a bottom prior to the National Bureau of Economic Research declaring a recession. If M2 portends a deflationary/recessionary period is forthcoming, it would mean stocks are nowhere near their bottoms just yet.
M2 is far from Wall Street's only concern
As I've pointed out in recent weeks, M2 is just one of many leading indicators forecasting a recession in the not-too-distant future.
One of the most-tracked recession probability tools is the New York Federal Reserve's recession probability indicator. This forecasting indicator measures the difference in yield (known as "spread") between the three-month and 10-year Treasury bonds. When yields invert -- short-term bonds have higher yields than longer-dated bonds -- it often suggests trouble ahead of the U.S. economy.
10 Year-3 Month Treasury Yield Spread data by YCharts. Gray zones denote recessions.
As of this past week, the size of the yield curve inversion between the three-month and 10-year Treasury notes hit its highest level since 1981. Meanwhile, the New York Fed's recession probability indicator suggests a 57.13% chance of a recession within the next 12 months. Over the past 56 years, a recession has occurred anytime this indicator has surpassed 40%.
Another prognosticating tool with a phenomenal track record of forecasting recessions is the Conference Board Leading Economic Index (LEI). The LEI takes 10 economic inputs into account and is presented as a six-month annualized growth rate.
Since 1949, anytime the LEI has declined by at least 4%, a recession has followed not long thereafter. The December reading for the Conference Board LEI came in at -4.2%.
Likewise, the U.S. ISM Manufacturing New Orders Index, a subcomponent of the better-known ISM Manufacturing Index (also known as the "Purchasing Managers Index"), portends trouble.
The ISM Manufacturing New Orders Index allows us to examine the strength of industrial orders in the United States. It's an index measured on a scale of 0 to 100, with 50 being the neutral baseline. A number above 50 implies industrial order expansion, while a figure below 50 suggests contraction. Before rebounding in February, the January 2023 reading was 42.5. Over the past 70 years, a figure below 43.5 has been a harbinger of a recession.
Image source: Getty Images.
Smart investors are continuing to put their money to work
Although M2 has a history of forecasting economic depressions or panics when it declines by at least 2%, it's important to note that all these events occurred between the 1870s and 1930s. The Federal Reserve has a far better understanding of how to adjust monetary policy to affect change(s) in the U.S. economy than it did 100 years ago.
Similarly, the federal government's ability to use fiscal policy measures to support the U.S. economy is considerably more refined today than in the 1870s and 1890s. While numerous indicators suggest an economic downturn is forthcoming, a depression doesn't seem likely.
What's more, M2 was increased by a considerable amount during the COVID-19 pandemic. Whereas a 2% or 3% decline in the money supply spelled trouble a century ago, the expansion of M2 from $15.3 trillion to nearly $21.3 trillion between December 2019 and January 2023 may allow for a sizable contraction without too much pain for the U.S. economy.
The point to be made is that even if an economic downturn is imminent, as so many indicators have suggested, smart investors will continue putting their money to work.
^SPX data by YCharts. Gray zones denote recessions.
Every year, market analytics company Crestmont Research updates its historic data on what an investor would, hypothetically, have generated in total returns, including dividends paid, if they'd purchased an S&P 500 tracking index at any point since the beginning of 1900 and held 20 years.
Among the 104 ending years examined (1919 through 2022), Crestmont found that every rolling 20-year period would have produced a positive total return. In fact, more than 40% of the end years examined would have resulted in an annualized total return of at least 10.8% over 20 years.
Though the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have their rough patches, they tend to increase in value over time. For long-term investors, it makes every double-digit percentage decline in these indexes an opportune time to buy high-quality stocks at a discount.
Editor's note: The spelling of Nick Gerli's name has been corrected.
