US money supply growth is accelerating and could signal a major shift in the stock market

Despite a few hiccups, S&P 500 the bull market is not slowing down. The stock index most commonly used to refer to the US large-cap stock market is up more than 20% through 2024 as of this writing.

But not all companies have participated equally in the current market rally. Only a few of the largest companies in the market have generated the vast majority of returns for the S&P 500. As a result, the index has become increasingly concentrated, with most of the value in just a few stocks.

More than 20% of the value of the 500-company index comes from just three stocks — Apple, Microsoftand Nvidia. The top 10 stocks account for about 35% of the index, the most since the 1960s.

While the largest companies are getting bigger faster than the rest of the market, it’s worth noting that increasing market concentration is unsustainable. At some point, the megacap stocks that lead the market today will be overtaken by smaller companies. And one market indicator suggests a big change is coming.

Image source: Getty Images.

The US money supply is accelerating

The US money supply can have a far-reaching impact on business and investor behavior. When a business has easier access to low-cost capital, it can grow much faster. But when money supply is tight, smaller companies struggle to grow and take advantage of business opportunities. Meanwhile, larger companies with deep pockets can take advantage of these opportunities while facing less competition.

According to the data collected by JP MorganHead of European Quantitative Strategy, Khuram Chaudhry, there is a correlation between a decrease in money supply growth and an increase in stock market concentration. The opposite is also true. When money supply growth accelerates, smaller companies can outperform, leading to less market concentration.

After several years of slowing growth, even some declines, US money supply growth is accelerating. The trend is expected to continue. This is how we got here.

Amid the onset of the COVID-19 pandemic in 2020, the Federal Reserve has set the target low for the federal funds rate at 0%. Meanwhile, the government sent stimulus checks to households to support the economy. The result was an increase in a measure of the US money supply called the M2 money supply. M2 includes cash in circulation, deposit accounts, money market accounts and certificates of deposit. Basically, if you can easily access the funds to pay for goods and services, it is included in M2.

Annual US Money Supply Data M2 by YCharts.

The money supply grew extremely rapidly in 2020 and continued to grow rapidly in 2021, although it could not maintain the torrid pace from multiple stimulus checks and a sharp drop in interest rates. Inflation was starting to become a challenge for many households, and eventually it became clear that the Fed needed to tighten the screws on the money supply.

Amid Fed policy tightening in 2022, M2 money supply growth has begun to slow rapidly. By the end of the year, growth entered negative territory as the Fed continued to raise interest rates. Supply contracted throughout 2023 and into the first quarter of 2024, even after the Fed halted its rate hikes.

But the M2 money supply is finally growing again. Not only that, but growth is accelerating rapidly. In April, the M2 money supply increased by about 0.6% year-on-year. This rose to 1.3% in June and reached 2% in the most recent reading in August. While M2 remains below the 2022 money supply peak, we are starting to see more liquidity in the market.

As noted, the money supply should continue to grow rapidly going forward. The Federal Reserve just instituted the first interest rate cut of 2020, a 0.5 percentage point cut. Two more cuts could come before the end of the year, and we could see rates fall by more than 1 percentage point next year as well.

This will make it less expensive to borrow, increasing the total amount of capital available to smaller companies. As a result, smaller stocks could lead the next leg up in the current bull market.

The best way to invest as money supply growth accelerates

The easiest way to invest in stocks when you expect market concentration to reverse is to buy an equal weight index fund. The Invesco S&P 500 ETF Equal Weight (RSP 0.36%) is one of the best in the industry, charging an annual expense ratio of just 0.2%.

With an equal-weight index fund, the fund manager invests the same amount of money in each of the components of the index. So they’ll put as much money into Apple, Microsoft, and Nvidia as the stocks numbered 498, 499, and 500. That way, if the larger companies underperform, the index won’t fall as much as the traditional cap. -S&P 500 weighted.

Of course, the opposite is also true. If megacaps continue to outperform, the equal weight index will underperform. It’s been that way for a while. However, the equal weight index historically produces very strong and prolonged periods of performance once concentration eventually peaks. And we may be approaching another peak.

Another option is to invest in small-cap stocks. These stocks aren’t represented in the S&P 500, but they face the same challenges as the stocks you’ll find at the bottom of the popular index. In fact, small caps may have been impacted even more by high interest rates, as many rely on floating-rate debt instead of long-term fixed-rate bonds.

My favorite index for small-cap stocks is the S&P 600, which tracks 600 of the smallest companies in the US market. The SPDR Portfolio S&P 600 Small Cap ETF (SPSM 0.67%) has an expense ratio of just 0.03%.

Like the S&P 500, the index has a profitability requirement for inclusion. As a result, the S&P 600 tends to lean toward value stocks. The return requirement can reduce the risk of investing in small-cap stocks. And profitable businesses with greater access to capital tend to become more profitable over time rather than consuming cash.

Despite the potential upside for small-cap stocks going forward, there is a large valuation discrepancy. The S&P 600 trades for just 15.3 times forward earnings, compared to a forward PE of 21.2 for the S&P 500. The large valuation gap between the indexes suggests that the market is underappreciating the potential of profitable small caps to accelerate earnings growth as the money supply . growth is accelerating.