Over long periods, the stock market sits on a mountain top overlooking all other asset classes. On an annualized return basis, stocks have delivered the superior return compared to gold, oil, housing, certificates of deposit (CD), and Treasury bonds.
But things can get dicey when you narrow the lens and look at the performance of equities over the short term. For instance, last year saw the iconic Dow Jones Industrial Average (^DJI 1.18%), broad-based S&P 500 (^GSPC 1.26%), and innovation-driven Nasdaq Composite (^IXIC 1.99%) fall into a bear market and deliver their worst single-year returns since the financial crisis in 2008.
Although investors have to be encouraged by the bounce the Dow Jones, S&P 500, and Nasdaq Composite have had, thus far, in 2023, certain indicators would suggest this bounce may be short-lived. One of those metrics comes from the banking industry and is sourced from the Board of Governors of the Federal Reserve System.
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This bank-lending metric is a potentially ominous sign for stocks
Before going any further, let me state the obvious: There is no perfect indicator or metric that can accurately forecast directional movements in the stock market over the long term. There are, however, indicators and metrics that have phenomenal track records of forecasting broad-market movements, and which have the potential to make investors' lives easier.
With that being said, the metric of interest in the banking industry has to do with commercial and industrial loans (commonly known as C&I loans). C&I loans are made to businesses to provide working capital or finance major projects or acquisitions. Typically, C&I loans are short term and backed by some form of collateral.
For the past 76 years, the aggregate amount of C&I loans outstanding from all commercial banks has grown substantially. Although C&I loans outstanding do tend to decline during and/or immediately after a recession, the long-term trend shows commercial banks are doling out more C&I loans over time.
What's of particular interest is a subcategory of C&I loans that examines the net percentage of domestic banks that are tightening standards for C&I loans to large and middle-market companies. In simpler terms, it's a measure of the percentage of commercial banks that are toughening their lending criteria with large- and mid-sized corporations. If lending is reduced to the companies that led the charge higher on Wall Street, the expectation would be for slower economic growth, or perhaps a recession.
US Net Percentage of Banks Reporting Tightening Standards for C&I Loans to Large and Middle-market Firms data by YCharts. Gray areas denote U.S. recessions.
This metric, which was put on my radar by Charlie Bilello, the chief market strategist at Creative Planning, has a history of predicting economic downturns. Within proximity of the 1990 to 1991 recession, 2001 recession, 2008 to 2009 recession, and 2020 recession, the net percentage of banks tightening C&I loan standards respectively peaked at 54.2%, 59.6%, 83.6%, and 71.2%.
But at the official start of each respective recession, the net percentage of commercial banks tightening C&I loans standards was 46.7% in 1990 to 1991, 50.9% in 2001, 32.1% in 2008 to 2009, and 41.5% in 2020, respectively. Note, the 2020 recession was unique in that it was caused by a pandemic and lasted just two months. Since this net percentage of the C&I loan-tightening metric is updated quarterly, I'm using the figure immediately following the COVID-19 recession.
As you can see from the chart, 46% of commercial banks are tightening their lending standards on C&I loans as of the latest report. That's pretty much right on par with where things stood during the start of the four previous U.S. recessions since 1990.
Once again, this doesn't mean a recession is imminent for the U.S. economy. However, tightening lending standards for C&I loans tends to be a harbinger of a U.S. recession.
This isn't the only financial metric ringing alarm bells
The thing is, this isn't the only financial metric that suggests turbulence lies ahead for the U.S. economy and stock market.
A little more than a week ago, I took a closer look at all commercial bank credit, which encompasses all loans and leases outstanding. For the past 50 years, bank lending has expanded by roughly 7% on an annualized basis. This is what we'd expect to see from an economy that continues to grow over the long term.
US Commercial Banks Bank Credit data by YCharts. Gray areas denote U.S. recessions.
But even banks have to do their due diligence when it comes to lending money. When interest rates rise, there's a growing likelihood of loan delinquencies or defaults. In other words, it means commercial banks are more mindful when it comes to approving loans and leases.
Over the past 50 years, there have only been four instances when U.S. commercial bank credit has declined at least 1.5% from its high. During the previous three instances in 1975, 2002, and between 2008 and 2010, the benchmark S&P 500 lost around half of its value. Despite a small bounce this past week, the fourth instance has occurred over the past few weeks.
U.S. money supply is another indicator that's raising eyebrows and ringing alarm bells. I'm specifically talking about M2 money supply, which factors in everything in M1 (cash bills and coins in circulation, along with traveler's checks) as well as savings accounts, money market funds, and bank CDs under $100,000.
During the pandemic, M2 catapulted higher by 26% on a year-over-year basis, which marked the biggest expansion of money supply on record. However, M2 has declined by 4.1% on a year-over-year basis through March 2023, representing its largest year-over-year decline since 1933.
US M2 Money Supply data by YCharts. Gray areas denote U.S. recessions.
In one respect, a 4.1% decline could mean nothing given how much M2 had expanded during the COVID-19 pandemic. On the other hand, previous declines in M2 of at least 2% haven't boded well for the U.S. economy or stock market. The four other occasions when M2 fell at least 2% led to three depressions and a panic between 1870 and the early 1930s. Admittedly, monetary and fiscal policy have come a long way since this period. Nevertheless, declining money supply may foreshadow a recession.
Since no bear market after World War II has bottomed prior to an official recession being declared, the implication is that the Dow, S&P 500, and Nasdaq Composite are headed to new lows in the coming quarters.
Here's why being an optimist pays on Wall Street
With so many indicators and metrics pointing to potential problems with the U.S. economy and stocks, it's not unnatural to feel some level of disappointment as an investor. After all, no one enjoys seeing unrealized losses or red arrows in their portfolio.
But there's absolutely no question that being an optimist pays off handsomely on Wall Street. Despite never knowing when recessions or stock market downturns will occur, a long-term mindset remains the key to success when investing.
Image source: Getty Images.
As an example, look back as far as you can see in the chart of the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite. While there have been dozens upon dozens of double-digit percentage declines throughout their history, all three indexes have eventually recouped all of the losses associated with corrections, bear markets, and crashes, and pushed to new all-time highs. Whether the stock market is firing on all cylinders or fear abounds, there's never been a bad time to put your money to work on Wall Street if you're a long-term investor.
In fact, market analytics company Crestmont Research successfully put this theory to the test. I reference Crestmont's dataset often because it represents the closest thing to a guarantee in the stock market.
What Crestmont did was analyze every rolling 20-year period for the S&P 500 since 1900. For instance, if a hypothetical investor purchased an S&P 500 tracking index in 1964, Crestmont analyzed what that investor would have earned on an annualized basis, including dividends, through 1983. Out of the 104 ending years it examined (1919 to 2022), every single one produced a positive total return. You simply couldn't go wrong for more than a century if you purchased an S&P 500 index fund and held it for 20 years.
Stock market downturns may be inevitable, but it's optimists that rule the roost on Wall Street.
