Putting your money to work on Wall Street has been quite the adventure over the past two years. We watched the Dow Jones Industrial Average (^DJI 0.40%), S&P 500 (^GSPC 1.02%), and Nasdaq Composite (^IXIC 2.02%) claw their way to multiple record-closing highs in 2021, plummet into a bear market in 2022, and now bounce back decisively since hitting their respective bear market lows last year. By one definition, all three indexes are in new bull markets.
However, the health of the U.S. economy continues to be a sizable overhang for the stock market and investors. Even though the economy and stock market aren't joined at the hip, economic weakness often leads to declines in corporate profits, which can have a deleterious effect on equities.
To add to the above, stocks have historically performed quite poorly in the first few months following the official declaration of a U.S. recession by the eight-economist panel of the National Bureau of Economic Research. In short, recessions are usually an ominous sign for Wall Street.
Image source: Getty Images.
America's top economic advisor doesn't believe a recession is coming
The silver lining for the Dow Jones, S&P 500, and Nasdaq Composite, which have all recently moved to 52-week highs, is that Treasury Secretary Janet Yellen, who was previously the chairperson of the Federal Reserve, doesn't foresee the U.S. economy dipping into a recession.
In a Bloomberg Television interview this past Monday, July 17, Yellen opined:
Growth has slowed, but our labor market continues to be quite strong. I don't expect a recession. I think we're on a good path to bringing inflation down. The most recent inflation data were quite encouraging that we're making progress on getting inflation down, but as I'd hoped and expected, that would occur in the context of a strong labor market.
The "recent inflation data" America's top economic advisor is referring to is the Bureau of Labor Statistics' June inflation reading, which showed an unadjusted trailing-12-month increase in the Consumer Price Index for All Urban Consumers (CPI-U) of just 3%. That's a far cry from the scorching-hot 9.1% CPI-U reading in June 2022.
Equally important, a meaningful uptick in the U.S. unemployment rate is typically observed during a recession. In June 2023, the U.S. unemployment rate stood at 3.6%, which is just a few tenths of a percent above a more than half-century low. While a decline in labor-force participation has certainly helped keep the unemployment rate low, the job market remains demonstrably strong.
In other words, stock market bulls appear to have plenty of evidence in their sails to suggest the Dow, S&P 500, and Nasdaq Composite can head even higher.
Following the money tells a different tale
However, things look markedly different for the U.S. economy and stock market if you literally follow the money.
U.S. M2 Money Supply data by YCharts.
For instance, we're witnessing the first meaningful decline in U.S. M2 money supply since the Great Depression. M2 money supply factors in everything you'd find in M1, such as cash bills, coins, and demand deposits from a checking account, and adds in saving accounts, money market funds, and certificates of deposit (CDs) below $100,000.
Since the U.S. economy expands over long periods, it's rare to see M2 money supply decline by at least 2%. In fact, it's only happened five times in the last 153 years. The previous four instances where M2 fell by at least 2% resulted in three depressions (1870s, 1921, and the Great Recession) and one panic (1893). All four instances led to deflationary contractions in the U.S. economy.
As of June, M2 money supply was 4.13% below its all-time high, set last year. Though this could be nothing more than a reversion to some sort of mean after a historic expansion of the money supply during the COVID-19 pandemic, history has shown that a shrinking money supply and above-average inflation rate don't mix well.
U.S. Commercial Banks Bank Credit data by YCharts.
But that's not all. We're also seeing commercial banks tightening their lending standards.
As of July 5, commercial bank credit of $17.27 trillion was 1.79% below the all-time high of $17.59 trillion set on February 15, 2023. A decline of 1.79% may not sound like much, but it's only the fourth such instance where commercial bank lending has fallen by at least 1.5% in 50 years. The three previous instances where notable declines in commercial bank lending were observed (1975, 2001, and 2009-2010) saw the S&P 500 lose around half of its value.
To build on this point, the net percentage of banks tightening their lending standards for credit card loans, as well as the net percentage of domestic banks tightening their lending standards for commercial and industrial (C&I) loans to medium and large middle-market companies, has climbed to levels that merit concern.
Banks are incented to lend to cover the costs associated with taking in deposits. If they're becoming pickier as to who they'll lend to, it's often a red flag for the U.S. economy and, therefore, the stock market.
Image source: Getty Images.
Relax, the long-term story offers a happy ending
Based on what following the money tells us, the U.S. economy seems more likely to enter a recession than to avoid one in the coming quarters. But things change pretty drastically when investors pan out a bit.
For instance, while there have been 12 U.S. recessions following World War II, they've all lasted just two to 18 months. That compares to periods of economic expansion, which have mostly been measured in years (note the plural).
It's no coincidence that the average bull market for the benchmark S&P 500 since 1929 has lasted 1,011 calendar days, while the average S&P 500 bear market clocks in at a much shorter 286 calendar days over the same stretch. Historically speaking, being optimistic is the path that smart, long-term investors are taking.
What's more, time really does heal all wounds on Wall Street -- at least when we're talking about the major indexes. Although the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have endured their fair share of double-digit percentage declines, bear markets, and crashes, throughout their storied existence, every single previous drop (save for the 2022 bear market) was eventually recouped -- and then some -- by a bull market rally.
For example, the Dow Jones lost nearly 90% of its value from peak to trough during the Great Depression. Yet pull up a linear (not logarithmic) chart of the Dow, and this monster decline in the early 1930s is hardly even visible. In fact, the total point loss for the Dow between September 1929 and its low, which was hit during the summer of 1932, wouldn't even equate to a 1% decline in the index today.
Even if the U.S. economy does fall into a recession, history suggests it'll be relatively short-lived and provide an opportunity for long-term investors to pounce on incredible businesses at a bargain valuation.
