Since this decade began, the iconic Dow Jones Industrial Average (^DJI +0.26%), benchmark S&P 500 (^GSPC +0.26%), and growth-focused Nasdaq Composite (^IXIC +0.35%), have vacillated between bull and bear markets. Although all three major stock indexes rallied more than 20% off of their 2022 bear market lows, and they appeared to be in the midst of establishing a new bull market, a multitude of economic datapoints suggest the declaration of a new bull market may be a bit premature.
While forecasting short-term directional movements in the stock market with 100% accuracy is impossible, five ominous charts strongly imply that the Dow Jones, S&P 500, and Nasdaq Composite remain firmly entrenched in a bear market.
Image source: Getty Images.
1. Money supply is meaningfully shrinking for the first time since the Great Depression
The first potentially concerning chart depicts changes in U.S. money supply over time.
There are two money supply metrics that economists pay close attention to: M1 and M2. The former factors in cash and coins in circulation, as well as demand deposits held in a checking account. Meanwhile, M2 takes everything in M1 and adds in money market accounts, savings accounts, and certificates of deposits (CDs) below $100,000. It's M2 money supply that's been raising eyebrows on Wall Street.
For well over a century, M2 has been moving higher with little interruption. That's because a steadily expanding economy will need more cash and coins to facilitate transactions. But in those rare instances where M2 declines by a meaningful amount, caveat emptor!
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
When back-tested to 1870, there have been four previous instances where M2 money supply fell by at least 2% on a year-over-year basis: 1878, 1893, 1921, and 1931-1933. All four of these instances led to deflationary depressions in the U.S. with high levels of unemployment.
For only the fifth time in 153 years, M2 money supply is meaningfully declining. As of October 2023, M2 was nearly 4.4% below its all-time high. While this might be nothing more than a benign reversion to the mean after a historic 26% year-over-year expansion of M2 during the COVID-19 pandemic, it could also be a crystal-clear warning that economic activity is set to slow. If the U.S. rate of inflation remains elevated and there are fewer dollars and coins available for consumers to make purchases, an economic slowdown is the expected result.
Historically, stocks have performed quite poorly during recessions.
2. Banks are visibly tightening their lending standards
A second worrisome chart that suggests the Dow, S&P 500, and Nasdaq never truly escaped the 2022 bear market is commercial bank credit.
Commercial bank credit encompasses loans and leases held by banks, such as commercial and industrial loans, real estate loans, and consumer loans (e.g., credit cards), as well as securities in bank credit, like mortgage-backed securities.
As a general rule, banks are incented to lend, both to generate a profit and cover the costs associated with taking in deposits. For as far back as the eye can see (and the data goes), aggregate bank lending has been increasing with very few hiccups. But when these "hiccups" arise, they're very telling.
US Commercial Banks Bank Credit data by YCharts.
During the week ending Oct. 4, 2023, commercial bank lending hit a 2.02% decline from the mid-February all-time high. This is the third time in 50 years that we've witnessed commercial bank lending fall by at least 2%. This decline signals to investors that banks are very clearly tightening their lending standards and becoming pickier with how they deploy their capital. That's not good news for the growth stocks that had previously powered Wall Street higher.
To boot, the two previous instances where commercial bank credit fell by 2% coincided with the broad-based S&P 500 losing around half of its value.
3. A leading recession-forecasting tool is nearing uncharted territory
The third ominous chart for investors is the Conference Board's Leading Economic Index (LEI).
The LEI is a 10-component index designed to predict shifts in the U.S. business cycle by roughly seven months. The LEI has three financial inputs, as well as seven non-financial components, such as ISM Manufacturing New Orders and private housing building permits, to name a few.
The Conference Board LEI is reported as a rolling six-month growth rate and typically compared to the prior-year period, as well as the sequential six-month growth stretch.
Leading Economic Index (LEI) from @Conferenceboard has declined for 18 consecutive months, which has only happened in recessions that took place in 1970s and 2007-2009 pic.twitter.com/MawkNTlbA0
-- Liz Ann Sonders (@LizAnnSonders) October 20, 2023
While there have been numerous instances since 1959 where the LEI has declined by 0.1% to 3.9% from the prior-year period, these very modest drops have, historically, served as periods of caution for the U.S. economy. However, year-over-year declines in the LEI of 4% or greater have always correlated with U.S. recessions, dating back 64 years.
As of September 2023, the LEI was lower by close to 8% from the prior-year period. This is a level synonymous with U.S. economic weakness in the not-too-distant future.
Furthermore, the LEI has declined for 18 consecutive months. This is nearing uncharted territory, with only the 1973-1975 (22 months) and 2007-2009 (24 months) declines in the LEI lasting longer. This recession-forecasting tool has simply never been wrong.
4. A historic yield-curve inversion may spell trouble
A fourth troublesome chart for Wall Street is the Treasury yield curve. The yield curve is a chart depicting Treasury yields for bonds and bills across a variety of maturity timelines.
Typically, the yield curve slopes up and to the right. This is to say that bonds maturing in 10, 20 or 30 years are going to have higher yields than Treasury bills maturing three or six months from now. The longer your money is tied up in an asset, the higher the yield should be in a healthy economy.
10 Year-3 Month Treasury Yield Spread data by YCharts.
However, when investors foresee potential trouble brewing, the yield curve can invert. In this instance, short-term bills sport higher yields than longer-maturing bonds. Although not every yield-curve inversion has been followed by a U.S. recession, all 12 U.S. recessions following World War II have been preceded by a yield-curve inversion. Think of a yield-curve inversion as a necessary ingredient for economic weakness.
But no two yield-curve inversions are alike. The yield curve inversion in 2023 has been the steepest in more than four decades. The Federal Reserve Bank of New York's recession probability tool is at its highest reading in more than four decades, which implies a high likelihood of a U.S. recession within 12 months.
5. Poor market breadth is a warning that shouldn't be ignored
The fifth ominous chart that strongly suggests the Dow Jones, S&P 500, and Nasdaq Composite are still in a bear market has to do with market breadth and the "Magnificent Seven."
In no particular order, the Magnificent Seven stocks are Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms. These are industry-leading businesses, and some of the largest publicly traded companies in the United States.
They're also stocks that have vastly outperformed through the first 10 months of 2023. The Magnificent Seven have played a key role in lifting the market cap-weighted Nasdaq 100, Nasdaq Composite, and S&P 500 to positive returns this year.
The Magnificent 7 now account for 29.6% of the total S&P 500 market cap, the highest level on record pic.twitter.com/TyIlSgjtkI
-- Barchart (@Barchart) October 14, 2023
Unfortunately, poor market breadth is rarely, if ever, a good sign for the stock market. According to Bank of America Global Research, the combined market cap of the Magnificent Seven recently hit almost 30% of the S&P 500. Whereas the benchmark index closed Oct. 26 with a year-to-date gain of nearly 8%, the equal-weighted S&P 500 was lower by more than 4% on a year-to-date basis.
The last time a small number of outperformers made up a sizable percentage of the S&P 500 was just prior to the 2022 bear market. Before that, it occurred immediately prior to the dot-com bubble bursting.
Historically speaking, a few top-performing companies propping up the broader market doesn't work for very long.
The only chart long-term investors should care about
Despite third-quarter U.S. gross domestic product coming in well ahead of expectations, a flurry of economic datapoints and predictive tools would appear to point to coming weakness in the U.S. economy and downside in the Dow, S&P 500, and Nasdaq Composite.
While this could very well mean increased volatility on Wall Street in the weeks and months to come, it's nothing to worry about for investors with a long-term mindset.
As much as investors might dislike volatility, uncertainty, and stock market corrections/bear markets, they're all a perfectly normal part of the long-term investing cycle. If anything, bear markets create valuation disconnects that allow opportunistic investors to buy high-quality stocks at a discount.
As you can see in the chart above, time has a way of healing all wounds on Wall Street. Despite never knowing when downturns will begin or how steep the decline will be, history shows that every significant drop has eventually been put in the rearview mirror by a bull market rally.
Furthermore, it's statistically smarter to be an optimistic long-term investor. Whereas the average S&P 500 bear market has lasted 286 calendar days since September 1929, according to an analysis by Bespoke Investment Group, the typical S&P 500 bull market has endured for 1,011 calendar days, or roughly 3.5 times as long.
There's no need to worry about the severity or timing of bear markets if you have time on your side.
