The US money supply is finally rising again and showing a big buy sign for these 3 ETFs

If there’s one thing that’s characterized the current bull market, it’s the rise of big tech stocks driving the next generation of innovations in artificial intelligence (AI). Capital has gathered in the biggest names in the market, including Nvidia, Microsoft, Alphabet, Amazonand Meta platforms. All five have played an important role in AI’s progress and together account for 63% of the S&P 500’s returns through the first half of 2024.

As a result of the meteoric rise of the world’s biggest companies, market concentration is near levels investors haven’t seen since the 1970s. While those big AI tech companies have produced solid earnings results, propelling and stocks higher, market concentration has always reversed course. A market indicator suggests that the market may be about to expand.

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The US money supply is finally growing again

Slowing money supply growth is usually linked to an increase in market concentration among large stocks, according to Khuram Chaudhry, head of European Quantitative Strategy at JP Morgan.

Think about it from a business owner’s perspective: If the money supply is tight, there is less access to cash to grow your business. If you’re already a very large business, however, you can generate enough cash from operations that you don’t have to worry about external financing. Investors understand this dynamic, and the big get bigger. This trend is exacerbated by the high capital requirements for building an AI business, which is what is currently driving the bull market.

The money supply grew rapidly in 2020 as the government injected cash into the economy with stimulus controls and the Federal Reserve cut interest rates to 0%. Starting in 2021, we saw the after effects of those policies begin to set in. Naturally, we saw slower growth as measured by the US M2 money supply. M2 includes cash in circulation, deposit accounts, money market accounts and certificates of deposit. Basically, any money that is readily available to businesses and consumers.

As the Fed continued to raise interest rates and further control the money supply in an effort to reduce inflation, we saw M2 money supply growth dip into negative territory by the end of 2022. It remained that way through the first quarter of the year 2024.

But the money supply is finally growing again, and its growth is accelerating. In April and May, M2 money supply rose 0.6% year-on-year. This rose to 1% in June and 1.3% in July.

Annual US Money Supply Data M2 by YCharts.

We could see further acceleration by the end of the year. The Federal Reserve is expected to announce the first interest rate cut of the cycle this month when the Federal Open Market Committee (FOMC) concludes its September meeting. As of this writing, more than 90% of futures traders currently expect the Fed to cut rates by at least 1 percentage point by the end of the year.

Based on Chaudhry’s analysis, as money supply growth accelerates, we should see a widening of the market. There are three major exchange-traded funds (ETFs) that investors can use to take advantage of the shrinking money supply.

1. Schwab Fundamental US Large Company ETF

Schwab Fundamental US Large Company ETF (FNDX 1.39%) it is an interesting index fund. It tracks an index that ranks and weights stocks based on fundamentals — adjusted sales, operating cash flow and cash returned to shareholders — instead of market capitalization like the S&P 500. The result is a much lower portfolio concentration than a benchmark S&P 500. fund, making it a great way to invest in market expansion without taking on a portfolio that deviates too much from other large-cap index funds.

Big companies like AppleMicrosoft and Berkshire Hathaway it still makes up a good portion of the portfolio (about 9.3% as of this writing), but much less than in an S&P 500 index fund. (Those stocks make up 15.3% of the S&P 500.)

The Schwab Fundamental Index Fund is effectively a contrarian investment. When the fund rebalances its holdings, it puts more money into stocks with declining fundamentals, while selling those that have outperformed fundamentals. This effectively weights the fund more towards high-value stocks.

With an expense ratio of 0.25%, the fundamental index fund is not the cheapest way to invest in index funds. But investors should see the less-focused fund outperform the top S&P 500 while maintaining decent exposure to the largest companies by fundamental measures.

2. Invesco S&P 500 Equal Weight ETF

The Invesco S&P 500 Equal Weight ETF (RSP 1.07%) tracks the equal-weight S&P 500 index. Instead of weighting each component of the S&P 500 by market capitalization, the equal-weight index fund simply invests an equal amount in each stock. This means that the returns produced by the smallest stocks are as important as the returns produced by Apple, Microsoft and Nvidia.

The index is rebalanced each quarter when the S&P 500 updates its constituents. This ensures that the index fund never strays too far from its equal weighting objective.

The equal-weighted index has historically outperformed the long-term cap-weighted S&P 500. Since the Invesco fund’s inception in 2003, it has produced an average compounded annual return of 11.63% versus 11.06% for the S&P 500. That said, the fund has significantly underperformed over the past three and five years. Its long-term success can be attributed to its diversification.

The equal weight index fund will outperform if the market expands. Smaller companies will outperform larger companies in the S&P 500, and the equal-weighted index will benefit as a result. With an expense ratio of 0.2%, it’s a cheap way to invest in large-cap stocks as money supply growth accelerates.

3. SPDR Portfolio S&P 600 Small Cap ETF

The SPDR Portfolio S&P 600 Small Cap ETF (SPSM 1.93%) tracks the S&P 600. The S&P 600 is similar to the S&P 500, but focuses on small-cap stocks. The index consists of approximately 600 consistently profitable U.S. companies with market caps ranging from approximately $150 million to $8.8 billion.

The S&P 600 is a little different from other small-cap indexes like the Russell 2000 because it has a profitability requirement. As a result, the index components are skewed towards value stocks. Small-cap stocks have historically outperformed every segment of the market over the long term. And as money supply growth accelerates, they could be set up for another period of outperformance.

The S&P 600’s valuation is also extremely attractive right now. As the big technology stocks with high valuations rose to dominate the S&P 500, the aggregate forward price-to-earnings ratio climbed to 20.2 times. Meanwhile, the S&P 600 has a total forward price-to-earnings ratio of just 14.5. This valuation gap is one of the largest in decades and makes the small-cap index extremely attractive.

The Invesco S&P 600 Index Fund is extremely cheap, with an expense ratio of just 0.03%. So if you expect easier access to capital to be a big boost for small caps, it could be one of the lowest cost ways to invest in an undervalued part of the market.