The US money supply has done something so remarkable it hasn’t happened since the Great Depression — and a big move in stocks may be coming

Over the past century, no asset class has outperformed stocks. While Treasuries, housing and various commodities like gold and oil have had moments of brilliance, nothing comes close to matching the average annualized return of stocks over very long periods.

But that doesn’t mean stocks go up in a straight line.

Although the stock driven mature Dow Jones Industrial Average (^DJI 0.55%)broad based S&P 500 (^GSPC 1.01%)and inspired by innovation Nasdaq Composite (^IXIC 1.13%) are firmly in a bull market, the dramatic selloff in stocks during the first three trading sessions in August served as a reminder that sentiment can change at any moment on Wall Street.

Image source: Getty Images.

On the one hand, there is no perfect indicator or predictive measure that can forecast these short-term directional movements in the Dow, S&P 500, and Nasdaq Composite with pinpoint accuracy. On the other hand, there are a variety of events and forecasting tools that have strong correlated with big moves in Wall Street’s three major stock indexes throughout history. These indicators and metrics are often aimed at investors in an attempt to gain an edge.

While there are some metrics that suggest trouble could be brewing for Wall Street, including the S&P 500’s Shiller price-to-earnings ratio and the New York Federal Reserve’s Recession Probability Tool, the data point with the longest perfect track record harbinger of a big move in stocks is the US money supply.

The US M2 money supply last did this in 1933

Although there are five different measures of the money supply, the two that are given the most credibility are M1 and M2. The premium is a measure of cash and coins in circulation, as well as demand deposits in a checking account. Essentially, it’s money you can spend right away.

Meanwhile, M2 takes everything in M1 and adds money market accounts, savings accounts, and certificates of deposit (CDs) under $100,000. This is still capital that can be spent, but it takes a bit more work to get there. It is also the value that has made history lately.

Usually, the money supply isn’t even something that investors are required to pay attention to. Over the past nine decades, the money supply has grown steadily. A growing economy in the long run will need more capital to facilitate transactions, so this steady tilt in the US M2 money supply is no surprise.

But in the highly notable cases where M2 has fallen, the problems have been for the US economy and stock market.

US M2 Money Supply data by YCharts.

Based on data released monthly by the Federal Reserve Board of Governors, M2 peaked in April 2022 at $21.722 trillion. The latest reading, from July 2024, shows US M2 at $21.054 trillion, a 3.07% decline in just over two years. While this is well outside the peak-to-trough drop of 4.74% from April 2022 to October 2023, it still marks the first sizeable drop in US M2 money supply since the Great Depression.

There are, however, a few caveats and asterisks to the data above that should be noted to give a more complete picture of what’s going on. For example, the money supply M2 actually increases again from year to year. In the last 12 months to July 2024, M2 expanded by 1.4% — and expansion is normal over the long term.

Additionally, M2 skyrocketed by over 26% year-on-year during the COVID-19 pandemic. The fiscal stimulus checks dumped money in the laps of many consumers and grew M2 faster than at any time since 1870.

Although the 4.74% decrease from peak to low from April 2022 to October 2023 May represents simple reversion to the mean, history has been pretty clear about what happens when the money supply M2 rebounds significantly from an all-time high.

WARNING: The money table is officially contracted. 📉

This has only happened 4 times in the last 150 years.

Each time a depression followed with double-digit unemployment rates. 😬 pic.twitter.com/j3FE532oac

— Nick Gerli (@nickgerli1) March 8, 2023

While the above social media post by Reventure Consulting CEO Nick Gerli is more than a year old, it makes a key point. Namely, that year-over-year declines of 2% or more in the M2 money supply are rare and historically associated with economic turbulence.

There have been only five occasions since 1870 when M2 has fallen by at least 2% from the previous year’s period: 1878, 1893, 1921, 1931 through 1933, and 2023. All four previous events correlate with periods of economic depression and two figures. unemployment in the US

The bottom line is that the Fed did not exist in 1878 and 1893, and in the 1920s and 1930s there was limited knowledge of how to fight fiscal and monetary challenges. With the understanding of monetary policy that Fed officials now have, along with the fiscal policy tools at the federal government’s disposal, it is a depression. extremely unlikely today.

However, the first notable decline in M2 since the Great Depression indicates that consumers need to cut back on discretionary spending. This tends to be a recipe for a recession.

Although the stock market does not reflect the performance of the US economy, a decline in economic activity would almost certainly weaken corporate earnings and hurt valuations. Historically, about two-thirds of the S&P 500’s peak-to-trough losses occur after, not before, a recession is declared.

Image source: Getty Images.

Patience and optimism produce the best investment results

Based on what history tells us about significant declines in the M2 money supply, one could expect a big move down in the Dow, S&P 500 and Nasdaq Composite that may even lead to a bear market.

Although stock market corrections, bear markets, and even crashes can sometimes be frightening and tug at the heartstrings of investors — especially newer investors who may not have experienced a rapid stock pullback before — taking a step back and practicing patience , and looking at the big picture has been a winning formula for investors since the early days of the stock market.

There is no doubt that recessions and economic downturns can be challenging for most Americans. The unemployment rate usually rises and the power to set wage prices shifts from workers to businesses during recessions. But these downturns tend to be short-lived, which works in favor of long-term investors.

Since the end of World War II in 1945, there have been a total of 12 recessions in the US. Three quarters of these recessions resolved in less than 12 months, none of the other three exceeded 18 months.

Comparatively, there have been two economic expansions that have exceeded the 10-year mark. Being optimistic and betting on the growth of the US economy over time was a smart move.

The thing is, what’s good for the US economy in the long run tends to be good for Wall Street.

It’s official. A new bull market is confirmed.

The S&P 500 is now up 20% from its 10/12/22 closing low. In the previous bear market, the index fell 25.4% in 282 days.

Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp

— Bespoke (@bespokeinvest) June 8, 2023

In June 2023, analysts at Bespoke Investment Group posted a dataset on X that looked at every bear and bull market for the S&P 500 since the start of the Great Depression in September 1929. This meant adding up the calendar duration of each major move above. and lower in the benchmark over 94 years.

As you can see, the S&P 500 market average remained only 286 calendar days, or the equivalent of 9.5 months. In contrast, the typical S&P 500 bull market lasted about 3.5 times longer (1,011 calendar days). For starters, 13 of 27 bull markets lasted longer than the S&P 500’s longest bear market.

Ultimately, we will never be able to predict with any guarantee when stock market corrections or bear markets will begin, how long they will last, or where the threshold will be. It may be difficult for investors to accept this realization.

But we know that over time, the Dow Jones, the S&P 500 and the Nasdaq Composite in the end (key word!) put these dips firmly in the rearview mirror. Having a long-term mindset and proper perspective can make it easier to navigate any big stock moves that might occur.