close
close

The US money supply recently did something for the first time since the Great Depression – which could signal a huge move in the stock markets

Posted on by darion

A historic move not seen in the M2 money supply in 90 years could spell trouble for Wall Street.

For the better part of two years, the bulls have been on a rampage on Wall Street. Only in 2024 an icon Dow Jones Industrial Average (^DJI 0.81%)reference point S&P500 (^GSPC 0.90%)and innovation-oriented Nasdaq Composite (^ixic 1.22%) all rose to multiple record highs.

But if history teaches investors anything, it’s that the stock market rarely moves up or down in a straight line. While there is no such thing as a forecasting tool that can specifically predict the future with 100% accuracy and accurately predict short-term directional movements in the Dow Jones, S&P 500, and Nasdaq Composite, that doesn’t stop investors from trying to gain an edge.

One such forecasting tool that has an excellent track record of correlating with significant stock market movements over over a hundred years is now heralding massive moves in the stock market.

A paper airplane using a twenty-dollar bill crashed and crumpled in the business section of the newspaper.

Image source: Getty Images.

The US M2 money supply did something no one had witnessed in 90 years

The forecasting tool in question that has a flawless track record when compared back to 1870 is the US money supply.

Although there are five different measures of the money supply, economists usually focus on M1 and M2. The first includes cash and coins in circulation, as well as demand deposits in the current account. In short, it’s money you have immediate access to and can spend.

Meanwhile, M2 takes everything found in M1 and adds savings accounts, money market accounts, and certificates of deposit (CDs) under $100,000. This is still money that consumers can access and spend, but it takes a bit more work to get there. It is also a measure of the money supply that serves as a warning to Wall Street.

With few exceptions, the M2 money supply increases and shifts to the right. This is a fancy way of saying that the amount of capital in circulation tends to increase over time, which is normal and expected given that the US economy grows at a relatively constant rate over the long term.

However, on the rare occasions that have occurred over the last 154 years when the M2 money supply has noticeably declined, this has been a moment to look back on the US economy and stock market.

US M2 money supply chart

US M2 money supply data from YCharts.

The U.S. M2 money supply is reported monthly by the Federal Reserve Board of Governors and peaked at $21.722 trillion in April 2022. According to the latest report for August 2024, the M2 value was $21.175 trillion, representing a decline of 2.52% in high compared to all-time values. Last year was the first year-over-year decline in the M2 money supply by at least 2% since the Great Depression.

However, as you will notice in the chart, the M2 money supply is growing again on a year-over-year basis. Despite M2 falling to a peak of 4.74% as of October 2023, this decline has almost halved in less than a year.

Moreover, even M2’s peak decline of 4.74% from its all-time high pales in comparison to the historic annual M2 money supply growth of over 26% recorded during the Covid-19 pandemic. Numerous rounds of fiscal stimulus have injected capital into the U.S. economy at an incredible pace. The decline we have witnessed over the past two-plus years may ultimately prove to be a mild reversion to the mean following the historic expansion of the U.S. money supply.

On the other hand, it could mean something more nefarious.

Although the above post, written by Reventure Consulting CEO Nick Gerli, is over a year old, it highlights a key correlation between year-over-year changes in the M2 money supply and the U.S. economy.

Since 1870, there have only been five occasions in which the M2 money supply declined by at least 2% year-over-year – these were the years 1878, 1893, 1921, 1931–1933, and 2023. The previous four events all correlate with periods of depression for American economy, as well as a double-digit unemployment rate.

Understand that there is quite a big caveat to this historical correlation. Namely, the Federal Reserve did not exist in 1878 or 1893, and both the central bank and the federal government had limited knowledge of how to counter the steep economic contractions and high unemployment in 1921 and during the Great Depression compared to today. With the knowledge and monetary/fiscal tools currently available, a recession would be highly unlikely.

However, the M2 money supply is still 2.52% below the record high set 28 months earlier. The significant decline in M2 suggests that consumers will have to forego some discretionary purchases, which has historically been a recipe for economic weakness, if not recession.

Based on research from Bank of America According to Global Research, about two-thirds of the peak-to-trough declines in the S&P 500 occur during, not before, a recession is declared. Thus, the historic decline in M2 that we have witnessed may signal massive declines in stock prices.

Businessman carefully reads a financial newspaper.

Image source: Getty Images.

The story varies greatly depending on the investment time frame

The prospect of a stock market correction or bear market is probably not something the investing community wants to hear about. However, history is a two-sided coin in many cases strongly favors investors who think long-term.

Despite all the benevolence in the world, recessions are a completely normal and inevitable part of the economic cycle. Since the end of World War II, there have been more than a dozen recessions in the US, which means that the economic situation deteriorates approximately every 6.6 years.

But what’s interesting about recessions is how quickly they subside. Of the 12 recessions that have occurred in the last 79 years, only three have exceeded the 12-month mark and none have lasted longer than 18 months. In comparison, most periods of growth lasted many years, with two economic expansions reaching 10-year periods.

Even though U.S. stocks and the economy are not in good shape, a steadily growing economy is expected to have a positive impact on corporate earnings over time. Earnings growth is a key factor driving higher stock valuations.

This discrepancy in perspective, based on investment time frames, is also easily identified on Wall Street.

In June 2023, shortly after confirming that the S&P 500 was in a new bull market (i.e., had rebounded more than 20% from the 2022 bear market low), researchers from Bespoke Investment Group published a set of data on social media, which can be seen above media platform

While the average S&P 500 bear market lasted 286 calendar days, or about 9.5 months, over a 94-year period, the typical bull market lasted 1,011 calendar days, or about two years and nine months.

Let us add that the longest bear market on the S&P 500 in history (630 calendar days), which took place from January 11, 1973 to October 3, 1974, is shorter than 13 of the 27 bull markets on the S&P 500. There were nine bull markets that lasted from 1,324 to 4,494 days calendar.

Even though we can’t predict in advance when stock market corrections will begin, how long they will last, or where the final bottom will be, nearly a century of history clearly shows that maintaining perspective and being optimistic is a winning formula on Wall Street.