Last year was an unpleasant but quite common reminder that stock market corrections are a natural part of the investing cycle. Over the past 73 years, there have been 39 separate double-digit percentage declines in the broad-based S&P 500 (^GSPC -0.22%), according to data from sell-side consultancy company Yardeni Research. This equates to a correction every 1.9 years (when rounded).

In 2022, the iconic Dow Jones Industrial Average (^DJI 0.06%), S&P 500, and growth-oriented Nasdaq Composite (^IXIC -0.52%) shed 9%, 19%, and 33% of their value, respectively. All three fell into a bear market during the year, too.

A twenty dollar bill paper airplane that's crashed and crumpled into the business section of a newspaper.

Image source: Getty Images.

Given the uncertainty and downside velocity that often accompany bear markets, the question on the minds of both new and tenured investors is simple: When will it end?

While timing bear market bottoms is difficult to do with anything other than hindsight as a guide, one indicator does have an uncanny track record of forecasting where stocks will head next under the right conditions. The key is for investors to literally follow the money.

The U.S. money supply offers a clue as to where stocks may be headed

For well over a year, I've offered a myriad of valuation-based metrics and economic data that can help predict where equities are headed when certain parameters are present. Another indicator that can be quite useful for investors is M2 money supply.

M2 is one of the two commonly followed money supply metrics. M1 accounts for money in circulation right now, such as cash bills and coins, whereas M2 takes into account everything in M1, along with savings accounts, money market funds, and certificates of deposit at the bank below $100,000. This money is pretty easy to get to, but it's not as tangible as having cash in your hand (as with M1).

According to a tweet this past week from Holger Zschäpitz, the economic and financial news senior editor of Die Welt in Germany, the U.S. M2 money supply fell by 2.4% on a year-over-year basis in February. This is the biggest decline we've witnessed in M2 money supply based on 63 years of data presented in Zschäpitz's tweet.

However, the CEO and founder of Reventure Consulting, Nick Gerli, used M2 and U.S. inflation rate data from the U.S. Census Bureau and Federal Reserve Bank of St. Louis to look back even further than 1960. Gerli found that over the past 153 years, there have been five instances when M2 fell at least 2% -- the four previous times this occurred, there were three depressions (the 1870s, 1921, and the Great Depression) and one panic in 1893. When M2 fell, unemployment also soared.

The idea is that as circulating and easily accessible money declines with an above-average inflation rate, something eventually goes wrong or breaks.

Some things to consider about using M2 as an economic/stock market forecasting tool

Based on more than a century of history, a decline in M2 would appear to provide a pretty big clue that the bear market isn't over and that stocks are possibly headed lower. However, there are some factors to consider if you're going to rely on M2 as a U.S. recession/stock market indicator.

To begin with, the M2 money supply grew on a year-over-year basis at its fastest clip in 150 years during the COVID-19 pandemic. Between multiple rounds of stimulus checks given to tens of millions of Americans and the nation's central bank gobbling up trillions of dollars in long-term Treasury bonds and mortgage-backed securities, the system became flooded with capital.

Even though a 2% decline in M2 has, historically, been a threshold where things tend to break, reverting to some form of mean after a 26% year-over-year increase during the pandemic may not warrant the same level of concern now as a 2% M2 decline did more than a century ago.

Another thing to consider is that the federal government and central bank have more knowledge about how their actions will impact the U.S. economy than they did between 1870 and 1932 when the three previous depressions and one panic occurred. In fact, the Fed didn't even exist when the 1870s depression and the panic of 1893 occurred. With better fiscal and monetary tools available, we'd unlikely see economic activity struggle to the extent observed between 1870 and 1932.

10 Year-3 Month Treasury Yield Spread Chart

A historically large yield curve inversion may portend trouble for the U.S. economy and Wall Street. 10 Year-3 Month Treasury Yield Spread data by YCharts. Gray areas denote U.S. recessions.

On the other hand, for M2 to be right about stocks moving lower, the U.S. economy would have to dip into a recession. Even though the U.S. economy and Wall Street are independent of each other, no bear market after World War II found its bottom prior to a recession being declared by the eight-economist panel of the National Bureau of Economic Research.

In this respect, M2 does appear to concur with a trio of economic indicators suggesting a growing likelihood of a U.S. recession. This includes the Federal Reserve Bank of New York's recession probability indicator, which examines the spread between the three-month and 10-year Treasury bond, the Conference Board Leading Economic Index, and the U.S. ISM Manufacturing New Orders Index, which has shown a slowdown in new industrial orders.

The smart money is thinking long term

Ultimately, predicting short-term movements in the Dow, S&P 500, and Nasdaq will always be something of an educated guess. Rarely, if ever, do all economic data and valuation-based indicators align to one direction or another over short periods. That's why smart investors are reliably looking to the horizon.

Don't get me wrong; it can be difficult to ignore wild swings in equities over the short run or overlook a rough day on Wall Street. But the picture changes pretty drastically when the lens is panned out beyond a few months or even a few years.

A person reading a financial newspaper while sitting at a table.

Image source: Getty Images.

One of the most telltale examples of using time as an ally is presented annually by market analytics company Crestmont Research. Crestmont examines what an investor would have received in total returns, including dividends, if they, hypothetically, had purchased an S&P 500 tracking index at any point since 1900 and held that position for 20 years. In total, 104 rolling 20-year periods were examined (1919-2022).

Crestmont found that buying and holding an S&P 500 tracking index for 20 years always resulted in a positive total return. For about 40% of all ending years, this hypothetical investor would have generated an annualized return of at least 10.8%.

Furthermore, each of the 38 previous corrections in the S&P 500 was eventually cleared away by a bull market rally. Though we'll never know how long corrections will last or how steep the declines will be, the data pretty conclusively shows that long-term-minded investors come out as winners.