On the surface, Wall Street offers one guarantee: unpredictability. Since this decade began, the three major stocks indexes -- Dow Jones Industrial Average (^DJI 0.40%), S&P 500 (^GSPC 1.02%), and Nasdaq Composite (^IXIC 2.02%) -- have been whipsawed by two bear markets (2020 and 2022) and a period of practical euphoria (2021) that saw equities rally to all-time highs.
Although there isn't an economic datapoint or predictive indicator that can, without fail, forecast short-term movements in the Dow, S&P 500, and Nasdaq Composite, there are a number of these tools that have uncanny correlations with directional stock market movements. One of the most-pronounced is U.S. money supply.
Image source: Getty Images.
U.S. money supply has made history on both ends of the spectrum
The two U.S. money supply metrics that investors tend to pay close attention to are M1 and M2. The former accounts for the cash and coins in circulation, as well as the demand deposits within an individual's checking account. Meanwhile, M2 factors in everything in M1 and adds money market accounts, savings accounts, and certificates of deposit (CDs) below $100,000. The main difference is that M2 factors in cash that takes a little extra work to get your hands on.
For as far back as the eye can see, M2 has been climbing. Since the U.S. economy steadily grows over the long run, it's only natural that more cash/capital is needed to facilitate transactions. In fact, M2 rising is so common that some economists may not even be paying attention to it as a monthly reported datapoint.
But in the rare event that M2 meaningfully declines, pay attention!
Back in March, Reventure Consulting CEO Nick Gerli posted what you see below on X, the social media platform formerly known as Twitter. It highlights M2 money supply growth and contraction dating back to 1870 using data supplied by the St. Louis Federal Reserve and the U.S. Census Bureau.
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
Over the past 153 years, there have only been five instances where M2 has declined by at least 2% on a year-over-year basis: the 1870s, 1893, 1921, 1931-1933, and 2023. In order, these instances resulted in a depression, panic, depression, Great Depression, and (insert your best guess here). In the previous four instances, it was an ominous sign for Wall Street.
As of July 2023, M2 money supply was 3.69% below the all-time high recorded in July 2022. This marks the first time since the Great Depression that we've witnessed a meaningful decline in U.S. money supply.
To be completely fair, the declines in the 1870s and 1893 occurred prior to the creation of the Federal Reserve, while the drops in 1921 and during the Great Depression came shortly after its creation. Today, there's a far better understanding from the nation's central bank and Capitol Hill on how to utilize monetary policy and fiscal policy, respectively, to avoid a depression.
Furthermore, multiple rounds of fiscal stimulus during the COVID-19 pandemic led M2 money supply to catapult higher by 26% on a year-over-year basis. It's always possible that the decline we're witnessing now of 3.69% represents nothing more than a return to some sort of mean after a historic expansion of M2.
However, history has been unkind to meaningful M2 money supply declines. With the core inflation rate more than double the Fed's long-term target of 2%, less capital in circulation would more than likely lead to a deflationary recession.
Money is a potentially big problem for the stock market
As I've pointed out previously, it's not just M2 that offers an ominous sign for the Dow Jones, S&P 500, and Nasdaq Composite. Following the money provides an assortment of indicators that potentially spells trouble for the stock market.
As an example, U.S. commercial bank credit is doing something right now that we've only seen happen four times in 50 years.
US Commercial Banks Bank Credit data by YCharts.
Every week, the Federal Reserve Board of Governors releases data on U.S. commercial bank credit -- i.e., the aggregate of loans and leases outstanding from commercial banks. Similar to M2, commercial bank credit is a figure that rises steadily over time. As the U.S. economy grows, so do the loan portfolios of our nation's banks. Plus, banks are incented to lend to cover the expenses associated with taking in deposits.
While there have been multiple blips since 1973 where commercial bank credit has dipped by a negligible amount, there have only been four instances where commercial bank lending dropped by at least 1.5%: 1975, 2001, 2009-2010, and 2023. As of Aug. 16, 2023, U.S. commercial bank credit was 1.92% below its record high, which was set on Feb. 15, 2023, just prior to the short-lived regional-banking crisis.
In the three previous instances where bank lending notably fell, the benchmark S&P 500 lost around half of its value. The growth-focused Nasdaq Composite was hit even harder during the declines in 2001 and 2009-2010.
If banks are reducing the amount of cash available for lending, it means less capital for businesses to hire, acquire, and innovate. In other words, it's a possible harbinger of a recession -- and the stock market has a dicey history during the early stages of 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.
It's a similar story with regard to the net percentage of banks reporting tightening standards for commercial and industrial (C&I) loans. A C&I loan is traditionally short-term, backed by collateral, and used by businesses for working capital, acquisitions, or to fund major projects.
Every quarter, the Federal Reserve Board of Governors releases its findings from the Senior Loan Officer Opinion Survey on lending standards. The third quarter report showed that 50.8% of domestic banks are tightening their lending standards for C&I loans to large and mid-sized businesses. This is a level that's consistent with previous recessions for the U.S. economy.
Following the money appears to lead to one conclusion: a downturn in the U.S. economy in the not-too-distant future.
This is the closest thing to a guarantee on Wall Street
Considering how well stocks have performed in 2023, an outlook that calls for a U.S. recession and a tough climate for equities in the coming quarters probably isn't what you'd expect. But the more investors widen their lens, the more predictable Wall Street becomes.
As much as investors might dislike stock market corrections, bear markets, and crashes, they're all a normal part of the long-term investing cycle. Over the past 73 years, there have been 39 double-digit percentage drops in the broad-based S&P 500, which works out to one every 1.89 years. While Wall Street doesn't adhere to averages, the point is to show that declines are a healthy part of long-term investing.
Image source: Getty Images.
Something else that's perfectly normal is having double-digit percentage declines completely erased by a bull market rally. With the exception of the 2022 bear market, every double-digit percentage drop in the Dow, S&P 500, and Nasdaq Composite dating back to their inception has, eventually, been cleared away by a bull market. Time is the ally that seemingly never lets investors down.
To demonstrate the power of time in the investment arena, the analysts at Crestmont Research analyzed the rolling 20-year total returns, including dividends paid, of the S&P 500 dating back to 1900. Although the S&P wasn't even created until 1923, its components could be found in other indexes prior to its creation. This allowed Crestmont to back-test its dataset, with accuracy, to 1900, which gave it 104 rolling 20-year periods of data (1919-2022).
Here's the kicker: All 104 periods produced a positive annualized total return. If an investor had, hypothetically, purchased an S&P 500 tracking index and held that position for 20 years, they made money, without fail, every single time. This is Wall Street's closest thing to a true guarantee.
Best of all, Crestmont's dataset showed that patience was extremely profitable most of the time. Whereas you could count on one hand how many ending periods produced annualized total returns of 3% to 5%, there were more than 50 periods that generated annualized total returns of 9% to 17.1%.
No matter what M2 money supply suggests is in store for the U.S. economy and Wall Street in the short-term, absolutely nothing beats having time as an ally.
