It's been a wild couple of years for Wall Street. In 2021, seemingly nothing could go wrong, with the iconic Dow Jones Industrial Average (^DJI -0.94%), broad-based S&P 500 (^GSPC -0.96%), and growth-centric Nasdaq Composite (^IXIC -1.18%) notching multiple record-closing highs. This was followed by last year's bear market, which saw all three indexes lose more than 20% of their value at one point.
In 2023, a "new" bull market has taken shape for the Dow, S&P 500, and Nasdaq Composite. While some investors believe a new bull market can't be declared until an index takes out its previous high, one of the more traditional definitions of a bull market is a 20% (or greater) rally following a 20% (or greater) decline. Based on this definition, all three indexes are firmly in a new bull market.
Although Wall Street sentiment has been decisively positive this year, one leading money metric suggests investors not get too comfortable with the "new" bull market.
This predictive money metric suggests trouble is on the horizon
One of the best ways for investors to gauge the health of the U.S. economy is to keep a close eye on banking activity.
In an expanding economy, businesses are, generally, eager to seek out loans to hire, acquire, and innovate. Meanwhile, banks are often more than willing to lend, since they have to cover the costs associated with taking in deposits.
One subset of the lending space can be particularly telling about the health of the U.S. economy: commercial and industrial loans (more commonly known as C&I loans). C&I loans are traditionally short-term, backed by collateral, and used by businesses of all sizes to provide working capital or to finance some form of major project. The aggregate amount of C&I loans outstanding from U.S. commercial banks has steadily climbed for well over a half-century.
However, when blips arise with C&I loans is when investors should pay attention.
Every quarter, the Federal Reserve Board of Governors provides data on the net percentage of domestic banks that are reporting an increasing in inquiries for C&I loans. It's a simple measure of how interested businesses of all sizes are in taking out loans that fuel major projects and acquisitions.
As you can see from the latest figure reported for the second quarter of 2023, there's been a historic drawdown in demand for C&I loans from businesses. Based on the reported data, C&I loan inquiries have fallen to at least a 20-year low, and are now below levels witnessed during the Great Recession.
Some of this decline may have to do with rapidly rising interest rates. The Federal Reserve has undertaken its most-aggressive rate-hiking cycle in 40 years. Higher debt-servicing costs are bound to turn some businesses off to the idea of borrowing money.
At the same time, lower C&I loan inquiries have also been a telltale warning in the past that businesses either see economic weakness in the not-too-distant future, or are already dealing with a challenging environment. In other words, this historic drop in C&I loan inquiries may signal a coming recession.
Multiple money metrics are sounding a warning
Interestingly enough, the C&I loan space isn't the only area we're seeing ominous signs. Following the money leads to a number of concerning indicators and metrics.
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
For example, U.S. money supply is notably shrinking for the first time since the Great Depression. Specifically, M2 money supply, which encompasses everything in M1 (cash, coins, and demand deposits in a checking account), and adds savings accounts, money market accounts, and certificates of deposit below $100,000, has fallen 3.75% from its all-time high set in July 2022. This is the first meaningful decline in M2 since 1933.
In one respect, a drop in M2 may, ultimately, be harmless. During the COVID-19 pandemic, M2 expanded by 26% on a year-over-year basis, which is a record when back-tested to 1870! A contraction following an otherworldly expansion could be needed without any ill effects to the broader economy.
Then again, fewer dollars and coins in circulation during a period of heightened inflation has, historically, been a very poor combination for the U.S. economy and Wall Street. The only other times in 153 years where M2 money supply fell by at least 2% resulted in three depressions (1870s, 1921, and Great Depression) and a panic (1893). History shows that when M2 meaningfully dips, a deflationary downdraft in the U.S. economy has followed. To boot, stocks usually perform their worst shortly after an official recession is declared.
Aggregate bank lending also offers a cautionary tale.
Commercial bank credit, which is reported by the Federal Reserve Board of Governors on a weekly basis, has risen on an almost uninterrupted basis over the past half-century. This relatively steady increase has to do with banks willingly lending money to cover the expenses associated with taking in deposits.
But since hitting an all-time high in February, commercial bank credit has dipped 1.63%. While this is a nominally small percentage, it marks only the fourth time in 50 years where commercial bank credit has fallen by at least 1.5%. The three previous times banks tightened their lending standards on virtually all types of loans, we witnessed the benchmark S&P 500 lose around half of its value.
The key point being that if banks are becoming stingier with their money, it's typically a bad sign for the U.S. economy and stock market.
Optimism is a long-term investors' best friend
Although a number of leading money metrics suggest the new bull market will be short-lived, history is pretty clear that long-term-minded investors have little to worry about.
Over the coming quarters, it's certainly possible the U.S. economy could weaken, which would be expected to have a negative impact on corporate earnings and stock prices, as a whole. But Wall Street has navigated these uncertainties before.
Since the start of 1950, there have been 39 separate double-digit percentage declines in the S&P 500, which works out to an average of one 10%+ drop every 1.89 years. Despite the relative frequency of notable corrections and bear markets on Wall Street, every previous decline (save for the 2022 bear market) was eventually recouped by a bull market rally. While it's true that we don't know precisely how long it'll take for the market to achieve new highs, time has always, eventually, healed all wounds for the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite.
It's official. A new bull market is confirmed.
-- Bespoke (@bespokeinvest) June 8, 2023
The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.
Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
Additionally, more than 90 years of historic data conclusively shows that being an optimist pays off.
Recently, wealth management company Bespoke Investment Group examined the aggregate time the S&P 500 spent in bull and bear markets since September 1929. Bespoke relied on the traditional definition of a bull and bear market, whereby a 20%+ rally or 20%+ decline equated to a new bull or bear market. In total, Bespoke tallied up the length of 27 bull markets and 27 bear markets in the S&P 500 over 94 years.
On average, the typical bear market has lasted just 286 calendar days. Meanwhile, the average bull market has spanned 1,011 calendar days. Put another way, the average bull market lasts a full two years longer than the average bear market.
No matter what happens in the months that lie ahead, patience and optimism tend to be rewarded handsomely on Wall Street.