Who needs a theme park when you have Wall Street. Over the trailing two years, we’ve watched the ageless Dow Jones Industrial Average (^DJI 0.84%), widely followed S&P 500 (^GSPC 1.23%), and growth-dominated Nasdaq Composite (^IXIC 1.45%), roar to new all-time highs, plunge into a bear market, and regain their luster, once more. This short-term roller-coaster ride has new and tenured investors alike wondering what’s next for Wall Street.
Although it’s not an economic datapoint most investors would think of turning to for guidance, U.S. money supply may hold the answer as to what’s next for stocks.
M2 money supply hasn’t done this since the Great Depression
Though there are a few variations of money supply, most economists tend to focus on M1 and M2. The former takes into account cash and coins in circulation, as well as demand deposits in checking accounts and traveler’s checks. In other words, money that’s either in your hand or can be accessed very easily.
Meanwhile, M2 accounts for everything in M1 and adds savings accounts, money market funds, and certificates of deposit (CDs) below $100,000. It’s money you have access to, but it takes a little extra effort to put this capital to work. It’s M2 money supply that’s raising eyebrows on Wall Street and making history.
During the COVID-19 pandemic, M2 soared by 26% on a year-over-year basis, which represents the steepest increase in U.S. money supply when back-tested to 1870. The issuance of multiple rounds of stimulus checks to the American public, along with pandemic-based programs for businesses, pumped capital into the U.S. economy at an extraordinary pace. Unsurprisingly, historically high inflation — 9.1% at the peak in June 2022 — soon followed.
What’s of interest is what’s happened to M2 money supply over the trailing year. Following a peak of $21.7 trillion in July 2022, M2 has fallen to a fresh reading of $20.81 trillion, as of May 2023. Although the May reading was higher than April and broke a nine-month downtrend, we’ve still witnessed a 4.1% aggregate drop in M2 from its all-time high.
Considering that M2 enjoyed a historic expansion during the pandemic, it’s certainly possible that a 4.1% decline can be shrugged off as nothing more than money supply reverting back to the mean. But history suggests otherwise.
Though history rarely repeats itself on Wall Street, it often rhymes. We haven’t seen a meaningful year-over-year decline in M2 money supply since the Great Depression in 1933.
WARNING: the Money Supply is officially contracting. 📉
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
— Nick Gerli (@nickgerli1) March 8, 2023
Thanks to a dataset supplied by Reventure Consulting CEO Nick Gerli, we also know that the only four times since 1870 where M2 contracted by at least 2% resulted in deflationary recessions for the U.S. economy. To be completely fair, these occurrences were in the 1870s, 1893, 1921, and the Great Depression. Two of these instances were prior to the formation of the Federal Reserve, and the understanding the nation’s central bank has of monetary policy has vastly evolved over the past century. Chances are that a steep depression wouldn’t occur in present-day America.
Nevertheless, declining money supply with an above-average inflation rate isn’t an ideal combination. If fewer dollars and coins are available to purchase goods and services, the expected response is for consumers and businesses to not buy as much. Historically speaking, that’s a recipe for a recession — and recessions can lead to sizable downside in the Dow Jones, S&P 500, and Nasdaq Composite.
Money could be the thorn in Wall Street’s first-half rally
The thing about M2 declining is that it’s far from the only money-based economic datapoint or indicator that’s signaling trouble. Although Wall Street largely shrugged off these concerns thanks to a big first-half rally in brand-name, megacap growth stocks, money may ultimately prove to be a thorn for Wall Street.
As an example, look no further than U.S. commercial bank credit. For 50 years, commercial bank credit has been moving decisively higher, to the point that few economists bother looking at the metric on a regular basis. This isn’t surprising given that the U.S. economy expands over long periods and banks want to lend money to cover the costs associated with taking in deposits.
While there have been blips over the past 50 years where U.S. commercial bank credit dipped a few tenths of a percent, there are only four instances where commercial bank lending declined by 1.5% or more. Three of those incidents (1975, 2001, and 2009-2010) saw the benchmark S&P 500 plunge by around 50%. The fourth is ongoing, with U.S. commercial bank lending down 1.75% from its peak in March 2023.
What this weekly reported datapoint tells us is that banks are tightening their lending standards. Whatever the specific reason is for banks adjusting their lending standards, the key point is that capital is becoming harder (and costlier with higher interest rates) to come by. Once again, that’s a formula for slower economic growth, if not a recession.
To add, we’re also seeing clear signs of bank hesitance when it comes to commercial and industrial (C&I) loans to large and middle-market companies. C&I loans are usually short-term and provide working capital to businesses so they can finance a big project or acquisition. Similar to commercial bank credit, C&I loans have steadily climbed over the long run as banks look to reap the rewards of the U.S. economy spending far more time growing than contracting.
Every quarter, the Board of Governors of the Federal Reserve System reports the net percentage of domestic banks tightening their lending standards for C&I loans to large and middle-market firms. The second-quarter update for 2023 showed that 46% of domestic banks are making it tougher to get a C&I loan. While there have been far higher incidences of loan tightening since 1990, this 46% mark is right around the level where previous U.S. recessions have been declared.
Wall Street is a numbers game that strongly favors the patient
Based on what we’re seeing from M2 money supply, commercial bank lending, and domestic banks tightening their lending standards for C&I loans, the ingredients for a U.S. recession are most definitely there. Stock losses have, historically, been most pronounced in the months that follow the official declaration of a recession by the eight-economist panel of the National Bureau of Economic Research.
However, Wall Street’s performance is largely dependent on your investment time frame. If you’re patient, these and other potentially worrisome money metrics represent nothing more than temporary white noise.
For instance, did you know that the S&P 500 has averaged a double-digit correction every 1.88 years since the start of 1950? Double-digit declines, as much as we might dislike them as investors, are a normal part of the investing cycle.
It’s official. A new bull market is confirmed.
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
— Bespoke (@bespokeinvest) June 8, 2023
At the same time, bull markets outlasting bear markets is a thing, too. According to calculations provided by wealth management firm Bespoke Investment Group, the 27 bear markets — defined as a 20% decline from recent highs following at least a 20% rally — the S&P 500 has navigated since 1929 have averaged 286 calendar days, or roughly 9.5 months. By comparison, the 27 bull markets over the same period have lasted an average of 1,011 calendar days, or approximately two years and nine months. On average, bull markets last 3.5 times longer than bear markets.
You can also clearly see the power of time on long-term charts of any major U.S. stock index. Take the Dow Jones Industrial Average as a perfect example. It lost nearly 90% of its value during the Great Depression, and has worked its way through a number of roughly 50-percentage-point pullbacks since it came into existence in 1896. Despite all the countless worries about the U.S. economy and the state of equities, the Dow has continually risen to new all-time highs over the long run.
Despite never knowing precisely when stock market downturns will occur, how long they’ll last, or how much the market will ultimately decline, history conclusively shows that the major indexes eventually work their way to new highs. Being patient and allowing the numbers game to work to your advantage is a formula for wealth creation that’s unmatched on Wall Street.