On October 12, Wall Street celebrated the two-year anniversary of the current bull market. The optimism among investors is clearly visible, even among the ageless ones Dow Jones Industrial Average (DJINDICES: ^DJI)benchmark S&P500 (SNPINDEX: ^GSPC)and growth-driven Nasdaq Composite (NASDAQINDEX: ^IXIC) reaching multiple all-time highs.
But if history has taught us anything, it’s that stock market corrections and bear markets are normal and inevitable. While no predictive measure is 100% accurate in predicting price movements lower in the Dow Jones, S&P 500 and Nasdaq Composite, there are a small number of events and data points that strong correlated with stock weakness throughout history. It is these events and data points that investors sometimes look to to gain an advantage.
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One of these highly correlative forecast numbers, which has a more than 150-year track record of predicting economic downturns in the US, portends trouble for Wall Street.
The one predictive tool that should raise eyebrows within the investment community is the US money supply.
While there are a number of ways to measure the money supply, the two with the greatest relevance are M1 and M2. M1 takes into account all cash and coins in circulation, traveler’s checks and demand deposits in a checking account. This is money that consumers can spend in an instant.
On the other hand, M2 takes everything from M1 and adds savings accounts, money market accounts, and certificates of deposit (CDs) under $100,000. This is still money that consumers have access to, but it requires more time and effort before it can be spent. It is this measure of the money supply that raises red flags.
Economists more or less ignored the M2 money supply for the vast majority of the past ninety years because it had been continually expanding. A steadily growing economy needs more capital in circulation to facilitate transactions.
But on those very rare occasions in history where notable declines in the M2 money supply have occurred, it has created problems for the US economy and Wall Street.
M2 is reported monthly by the Board of Governors of the Federal Reserve System. In April 2022, it reached an all-time high of $21.723 trillion. But between April 2022 and October 2023, the US M2 money supply would decline by a peak of 4.74% from this record high.
This marked the first decline of at least 2% in the M2 money supply from a record high, as well as the first year-on-year decline of at least 2% since the Great Depression.
Before we dig deeper, we should be aware that there are two caveats to this meaningful decline in the M2 money supply.
First, M2 is climbing again. Based on the September 2024 value of $21.221 trillion, the M2 is up 2.7% year-over-year, which would be generally good news for the US economy. Overall, M2 is still 2.31% below its all-time high.
Second, this peak-to-trough decline in the US M2 money supply followed a historic year-over-year expansion of over 26% during the height of the pandemic. Fiscal stimulus and historically low interest rates flooded the U.S. economy with capital. In other words, it is possible that this decline in M2, which occurred for the first time in ninety years, is a benign reversion to the mean after an unprecedented expansion in the money supply.
However, more than a century of history suggests that this decline could have more ominous consequences.
In March 2023, Nick Gerli, the CEO of Reventure Consulting, published the message you see above on the social media platform X (formerly known as Twitter). Using data from the Federal Reserve and the US Census Bureau, Gerli was able to backtest the growth and contraction of the M2 over a period of more than 150 years.
Although this post is over a year old, it highlights important correlations between the rare year-over-year declines in the US M2 money supply and the deep weakness of the US economy.
Since 1870, there have only been five instances in which the M2 fell by at least 2% on an annual basis: 1878, 1893, 1921, 1931–1933, and 2023. All four previous events correlate with a US depression and double-digit unemployment rate.
Again, there is a caveat to this data. More specifically, the Federal Reserve did not exist in 1878 or 1893, and the fiscal and monetary policy tools and knowledge available today far exceed what was known and understood in 1921 and during the Great Depression . In short, there would be an American depression incredible This is unlikely to occur in modern times.
Nevertheless, the largest peak-to-trough decline in the M2 since the Great Depression signals the possibility that consumers will have to scale back their discretionary spending. Traditionally, this is a key ingredient for an economic downturn.
Based on research by Bank of AmericaRoughly two-thirds of peak-to-trough declines in the S&P 500 occur after, not before, a recession is declared.
But while history portends trouble for Wall Street in the coming quarters, time remains an undeniable ally for investors willing to take a step back and look to the horizon.
As much as workers and investors hate economic downturns, they are – like stock market corrections and bear markets – an inevitable part of the economic cycle. But what is important to recognize is that ups and downs within the economic cycle are not mirror images of each other.
Since the end of World War II in September 1945, the American economy has fought its way through a dozen recessions. Of these twelve recessions, nine were resolved in less than a year, and the remaining three in eighteen months or less.
At the other end of the spectrum, the vast majority of economic expansions stalled for several years, including two periods of growth that exceeded the ten-year mark. Investors who counted on the US economy to grow over the long term have been richly rewarded – and the same can be said for those who bet the stock market will move higher over time.
In June 2023, shortly after it was confirmed that the S&P 500 was in a bull market after bottoming out in the 2022 bear market, researchers at Bespoke Investment Group published the message you see above on X. Bespoke calculated the calendar day length of every bear and bull market in the S&P 500 dating back to the start of the Great Depression in September 1929.
Bespoke’s dataset shows that the average bear market in the S&P 500 lasts just 286 calendar days, or about 9.5 months. By comparison, the typical bull market in the S&P 500 over a 94-year period lasted 1,011 calendar days, or about 3.5 times longer than the average bear market.
Furthermore, 14 of the 27 bull markets – including the current one – have lasted longer than the S&P 500’s longest bear market ever.
Regardless of the sophisticated software you use or the historical data points you rely on, you will never be able to concretely determine which direction the Dow Jones, S&P 500 and Nasdaq Composite will take in the short term.
But history is very clear that Wall Street’s major indexes and the most influential companies in the stock market will increase in value over time. Letting time work its magic makes even the most terrifying historical data points seem benign.
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Bank of America is an advertising partner of The Ascent, a Motley Fool company. Sean Williams has positions at Bank of America. The Motley Fool holds and recommends Bank of America. The Motley Fool has a disclosure policy.
The US money supply recently did something not seen since the Great Depression – and it could foreshadow trouble for Wall Street. was originally published by The Motley Fool
