This has been a pretty wild decade for new and tenured investors. It began with the COVID-19 bear market crash in 2020, was subsequently followed by a ferocious bull market in 2021, and saw the Dow Jones Industrial Average (^DJI +0.75%), S&P 500 (^GSPC +0.77%), and Nasdaq Composite (^IXIC +0.88%) plummet into their second bear market in as many years in 2022.
Since 2023 began, unbridled optimism has, once again, run wild on Wall Street. The benchmark S&P 500 and growth-driven Nasdaq Composite are higher by 16% and 30% on a respective year-to-date basis, as of Aug. 11. Further, all three indexes, including the Dow Jones, have rallied more than 20% off of their 2022 bear market lows. By at least one definition, Wall Street is back in a bull market.
However, one telltale warning for Wall Street suggests the latest running of the bulls could ultimately be nothing more than an epic bear market rally.
Image source: Getty Images.
Banks are meaningfully hitting the brakes for only the fourth time in a half-century
Investors have no shortage of economic data points that they're able to comb through. They receive monthly updates on the U.S. employment rate, inflation rate, and retail sales, just to name a few. But it's not always the headline figures that tell the best stories.
Every week, the Board of Governors of the Federal Reserve System releases data on the assets and liabilities of commercial banks in the United States. Specifically, this report contains an aggregate of all bank credit by U.S. commercial banks.
Over the past 50 years (i.e., as far back as the Federal Reserve Bank of St. Louis' data goes), commercial bank credit has climbed from $567 billion to well over $17 trillion with little interruption. Since banks need to cover the costs associated with taking in deposits, a relatively steady long-term increase in lending is perfectly normal.
But once in a blue moon, a meaningful decline in commercial bank credit occurs.
US Commercial Banks Bank Credit data by YCharts.
Over the past 50 years, there have only four instances where aggregate lending by U.S. commercial banks declined by more than 1.5% from an all-time high. As you can see in the chart, the fourth instance is occurring right now, with total bank credit down just shy of 2% from the Feb. 15, 2023, record high.
What this decline signals is that banks are very clearly hitting the brakes and tightening their lending standards as interest rates climb at the fastest pace in roughly four decades. The only time banks meaningfully tighten their lending standards and slow down loan origination is when they see trouble brewing with the U.S. economy, or if they're already contending with headwinds.
The short-lived regional banking crisis from earlier this year still has investors on edge. This series of tumultuous events saw SVB Financial's Silicon Valley Bank, Signature Bank, and First Republic Bank all get seized by regulators. With bank liquidity clearly in focus, banks are being more mindful of where they're putting their money to work.
The previous three instances where U.S. bank credit pared back by more than 1.5% since 1973 all saw the benchmark S&P 500 lose in the neighborhood of half of its value. In other words, it's a very telltale warning for Wall Street to be on the lookout for an economic slowdown and a downturn in stocks.
U.S. money supply offers its own ominous message
However, declining bank credit among U.S. commercial banks is just one of a handful of money-focused data points that appears to spell trouble for the stock market. Based on historic precedence, maybe no data point offers a more ominous message for Wall Street than U.S. money supply.
The two money supply metrics that are the most closely followed are M1 and M2. The former factors in the cash and coins in circulation, as well as demand deposits available in a checking account. Meanwhile, M2 accounts for everything in M1 and adds in money market accounts, savings accounts, and certificates of deposit below $100,000. M2 is the money metric currently sounding a warning.
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
Similar to bank credit, M2 money supply has expanded with virtually no interruption for more than a century. This is to be expected, with more cash and coins needed in circulation to cover transactions for an economy that's steadily expanded, when examined over long periods.
There have, however, been five instances where M2 declined by at least 2% from its record high. When back-tested to 1870, M2 has dropped by at least 2% in the 1870s, 1893, 1921, during the Great Depression, and in 2023 (currently 3.75% below the July 2022 high). For context, the previous four instances where M2 meaningfully fell resulted in a deflationary downturn for the U.S. economy, if not a full-blown depression.
Even though the all-encompassing measure of inflation, the Consumer Price Index for All Urban Consumers (CPI-U), is well off of its June 2022 peak (9.1% on a trailing-12-month (TTM) basis), U.S. core inflation (4.7% on a TTM basis, as of July 2023) remains considerably higher than the Fed would like. With M2 money supply shrinking, it means fewer bills and coins are in circulation as the price for goods and services climbs above historic norms. That's typically a recipe for an economic slowdown.
Perhaps the one solace for investors is that M2 money supply expanded by a record 26% year over year during the early portion of the COVID-19 pandemic. This may mean the current drop in M2 is completely benign. Unfortunately, history would suggest otherwise.
Image source: Getty Images.
Here's a result investors can truly bank on
Although I'm reluctant to rain on the bulls' parade, there are very clear signs from the banking industry, and via other money metrics, that economic activity in the U.S. is set to slow in the coming quarters. Should that happen, it's quite possible, if not probable, that the Dow Jones, S&P 500, and Nasdaq Composite will head considerably lower.
Then again, predicting short-term directional movements in the stock market is impossible to do with any sustained accuracy. If investors want results they can truly bank on, they'd be wise to look to the horizon.
Every year, market analytics company Crestmont Research updates its extensive dataset that analyzes what an investor would have generated in total returns, including dividends, if they'd hypothetically purchased the S&P 500 and held that position for 20 years.
What makes Crestmont's dataset so unique is that researchers were able to back-test their calculations all the way to 1900. Even though the S&P didn't exist prior to 1923 and didn't contain 500 components until 1957, the representative companies in the S&P could be found in other major indexes prior to 1923. This allowed for accurate back-testing to 1900, as well as 104 rolling 20-year periods of total returns data (1919-2022).
The results show that every single rolling 20-year period produced a positive annualized total return -- that's 104 out of 104. In other words, you made a profit regardless of when you put your money to work in the S&P 500, as long as you held that position for 20 years.
Furthermore, in approximately 50 of the rolling 20-year periods, the annualized total return was at least 9%. Patient, long-term investors weren't just eking out a profit. In many instances, they were generating annualized total returns that absolutely blew away the prevailing rate of inflation.
Getting from Point A to B doesn't occur in a straight line on Wall Street. But conviction and patience has consistently generated results investors can bank on.
