For more than a century, Wall Street has been a proven moneymaker that's outpaced the likes of commodities, housing, and bonds on an annualized return basis. But when examined over shorter periods, the stock market becomes highly unpredictable.
Although the ageless Dow Jones Industrial Average (^DJI +1.79%), broad-based S&P 500 (^GSPC +1.20%), and growth-fueled Nasdaq Composite (^IXIC +1.52%), have bounced meaningfully off of their 2022 bear market lows, the latter two have also entered correction territory.
With Wall Street being whipsawed, investors are looking to a variety of economic datapoints and predictive indicators to potentially get an edge in deciphering which direction the Dow Jones, S&P 500, and Nasdaq Composite will head next.
Image source: Getty Images.
While there's no such thing as a foolproof indicator that can, with concrete accuracy, forecast directional moves in stocks, there are a handful of economic tools that have exceptionally strong correlative track records to directional moves for the major stock indexes. One such indicator, which is doing something truly historic at the moment, is U.S. money supply.
This hasn't happened since 1933, and it may portend a big move to come for stocks
U.S. money supply has four measurement standards, of which M1 and M2 are, by far, the most popular. M1 takes into account cash and coins in circulation, as well as easily accessible cash, such as traveler's checks and demand deposits in a checking account. Meanwhile, M2 factors in everything in M1 and adds money market accounts, savings accounts, and certificates of deposit (CDs) below $100,000. Think of this as capital that's still within reach, but it requires more work to get to. This latter measurement, M2, is what's turning heads on Wall Street.
Typically, M2 money supply is an afterthought for investors and most economists. Since the U.S. economy expands over long periods, and more cash and coins are needed to facilitate transactions in a growing economy, M2 money supply has risen pretty steadily over many decades. In other words, there isn't much sense in closely monitoring a datapoint that seemingly increases without fail.
US M2 Money Supply data by YCharts.
But something interesting has happened over the past 15 months. Since M2 reached $21.7 trillion in July 2022, this oft-overlooked datapoint has declined.
Mind you, very small moves lower in M2 money supply have occurred dating back more than a century. But there have only been a small handful of instances -- five, to be exact -- where M2 has meaningfully declined by at least 2% on a year-over-year basis. Four of these previous drops occurred in 1878, 1893, 1921, and 1931-1933. The fifth instance, and first since the Great Depression, is ongoing right now, with M2 money supply down 3.17% from the prior-year period, and 4.37% from the July 2022 peak, as of September 2023.
The significance of this decline is twofold. To start with, there are economic implications of having less capital in circulation. With core inflation still well above historic norms due to higher shelter expenses, consumers may be forced to pare back their discretionary purchases. In other words, declining M2 sets the stage for a potential downturn in the U.S. economy.
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
The second thing to note about the four previous notable dips in M2 is that they all led to deflationary depressions with double-digit unemployment rates. Keep in mind that the Federal Reserve didn't exist in 1878 or 1893, and the Fed Board of Governors has a much better understanding of how their monetary tools can strengthen the U.S. economy today than they did a century ago. The point being that a depression with double-digit unemployment is far less likely today that it was in the early 20th century.
Nevertheless, a meaningful decline in U.S. money supply can't be swept up the rug -- even if it comes after a historic expansion of M2 during the COVID-19 pandemic. If a recession were to take shape, history suggests stocks could head considerably lower, at least in the short term.
Following the money paints a potentially worrisome short-term picture for Wall Street
But as I've noted in the past, M2 is just one of a number of money-based metrics that appears to be sounding some sort of warning to Wall Street that turbulent times may lie ahead.
Perhaps an even bigger warning than what M2 is signaling can be found with the chart of U.S. commercial bank credit. For context, commercial bank credit encompasses aggregate loans and leases, as well as securities held by banks, such as mortgage-backed securities.
US Commercial Banks Bank Credit data by YCharts.
Similar to M2, commercial bank credit has been on a relatively steady upward slope for the past 50 years. A growing economy means more outstanding loans and leases. Further, banks are incented to lend in order to cover the costs associated with taking in and holding deposits.
However, there's been a marked drop in commercial bank lending since hitting an all-time high in mid-February 2023. As of the week ended Oct. 18, 2023, U.S. commercial bank credit has declined by 2.06%. That may not sound like a lot, but it marks only the third time since January 1973 that we've witnessed a peak drop-off in commercial bank credit of more than 2%. The other two incidences occurred in October 2001 (2.09% peak decline) and March 2010 (6.94% peak decline), and they correspond with big declines in the benchmark S&P 500.
A more than 2% drop in commercial bank credit makes clear that financial institutions are tightening their lending standards and making it harder for businesses to access fresh capital. This may spell trouble for the growth stocks responsible for pushing the stock market higher.
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.
The third quarter Senior Loan Officer Opinion Survey on Bank Lending Practices from the Board of Governors of the Federal Reserve adds fuel to the proverbial fire.
This survey showed that nearly 51% of domestic banks are tightening their lending standards when it comes commercial and industrial (C&I) loans to medium-sized and large companies. C&I loans are typically short-term, collateralized loans that businesses use for working capital, deal-making, and major projects. If businesses are having a harder time accessing capital, the takeaway would be to expect economic growth to weaken in the coming quarters.
I'll also add that any net tightening reading for C&I loans by domestic banks north of 50% has been consistent with a U.S. recession, dating back to 1990.
Image source: Getty Images.
Perspective changes everything on Wall Street
Following the money doesn't exactly offer a rosy outlook for stocks in the very short term.
But the funny thing about Wall Street is that your investment horizon changes everything. If you're a short-term trader, things may be looking dicey at the moment. But if you have a long-term mindset, turbulence is nothing more than opportunity in disguise.
As much as we may dislike recessions and stock market corrections, they're both perfectly normal and expected parts of the economic and investment cycle. Most importantly, they're also both short-lived.
The U.S. economy has endured one dozen recessions since World War II ended. Only three of these 12 economic downturns made it to the 12-month mark, with only one reaching 18 months. By comparison, a majority of economic expansions lasted multiple years, with one surpassing a decade.
This disproportionate upside and optimism can be seen dating back nearly a century on Wall Street. Whereas the average S&P 500 bear market since September 1929 has lasted 286 calendar days (roughly 9.5 months), wealth management company Bespoke Investment Group finds that the average S&P 500 bull market has endured 1,011 calendar days, or about 3.5 times as long. While skeptics will, eventually, be correct, the numbers very much favor long-term optimists.
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
Best of all, time is undefeated on Wall Street.
Recently, Bank of America Global Research released data that examined the probability of negative returns, relative to the S&P 500's total returns, based on the length of various holding periods. BofA's analysis found an inverse correlation between negative return probability and holding time, dating back to 1929.
Whereas hypothetically holding an S&P 500 tracking index for one day would have resulted in a negative return 46% of the time over the past 94 years, extending this holding period to three months or one year would have reduced the probability of losses to 32% and 25%, respectively. However, holding an S&P 500 tracking index over 20 years, inclusive of dividends, has been a surefire moneymaker for more than a century.
Perspective changes everything on Wall Street. As long as you have a long-term investment horizon, short-term declines are nothing more than ideal opportunities to buy high-quality stocks and/or exchange-traded funds on the cheap.
