The U.S. money supply is doing something so rare it hasn’t happened since the Great Depression — and a big stock rally could be coming

Over long periods, Wall Street has demonstrated that it is a wealth-creating power. Compared to other asset classes, including gold, oil, real estate, and Treasuries, stocks have significantly outperformed in terms of annualized return over the past century.

But when you look at just a few months or years, the performance of broad market indices becomes much harder to predict. In fact, the timeless Dow Jones Industrial Average (DJ CLUES: ^ DJI)reference S&P500 (INDEXSNP: ^GSPC)and fueled by growth stocks Nasdaq Composite (NASDAQ INDEX: ^IXIC) traded bear and bull markets in successive years during the first four years of this decade.

When the stock market is volatile, it’s only natural for investors to look for clues that might indicate which direction stocks will take next. While there are no predictive indicators or metrics that can predict with concrete accuracy the direction major stock indexes will go, that doesn’t stop investors from trying to gain an edge.

However, there are a small number of indicators that are highly correlated with historical upward or downward movements in the Dow, S&P 500 and Nasdaq Composite.

One of these predictive tools, which hasn’t sounded the warning we see today since the Great Depression, appears to portend trouble for the U.S. economy and a big move ahead for stocks.

This is a first for the American money supply in more than 90 years.

The forecasting measure I alluded to above is the US money supply. Although the U.S. money supply has five different measures, the two measures of most interest are generally M1 and M2.

The M1 money supply takes into account cash and coins in circulation, as well as demand deposits in a current account. Think of it as money that is very accessible and can be spent in the blink of an eye. Meanwhile, M2 takes into account everything in M1 and adds savings accounts, money market accounts, and certificates of deposit (CDs) under $100,000. It’s still accessible money, but it takes a little more work to get and spend it. It is this category, the M2 money supply, that is of concern.

Normally, little attention is paid to the M2 money supply. That’s because it has increased virtually continuously over the past nine decades. With the growth of the U.S. economy over time, it is not surprising that more capital was needed to facilitate transactions.

What is abnormal is a decline in the US money supply – and that is exactly what we are currently seeing with M2.

The story continues

In April 2022, the Board of Governors of the Federal Reserve reported that M2 reached an all-time high of $21.722 trillion. For some context, this is an increase from $286.6 billion in January 1959 and represents a compound annual growth rate of about 7 percent. But as of April 2024, M2 stood at $20.867 trillion, representing a decline of nearly $855 billion – 3.94% percentage – in two years. This is the first time that the M2 money supply has fallen by more than 2% compared to its historic high since the Great Depression.

The not-to-be-ignored condition of this decline is that M2 exploded 26% year-over-year at the height of the COVID-19 pandemic. Multiple rounds of fiscal stimulus from the federal government, coupled with low interest rates, flooded the U.S. economy with capital that rapidly expanded the money supply. It can be argued that the nearly 4% retracement of M2 over the past two years is nothing more than a normalization after a historic expansion.

I’ll also point out that M2 actually increased year over year. Although it is down 3.94% from its April 2022 all-time high, M2 is up a very modest 0.14% from its level a year ago.

Still, history has been very clear about what happens every time the M2 money supply declines at least 2% from its peak – and that’s not good news for Wall Street or the economy American.

As you can see in the above post from Reventure Consulting CEO Nick Gerli on social media platform X (formerly Twitter), year-over-year declines of at least 2% in M2 are quite rare. Using data from the Federal Reserve and the U.S. Census Bureau, Gerli was able to test these percentages of change in the U.S. money supply since 1870. During this period, only five cases were observed where M2 decreased by at least minus 2% over one year. -year: 1878, 1893, 1921, 1931-1933 and 2023.

The previous four instances of M2 declines of at least 2% correlated with depressions and double-digit unemployment rates for the U.S. economy.

The good news is that the Federal Reserve and the federal government are much better informed today about how to deal with economic turmoil than they were a century ago. The Fed didn’t exist during the depressions of 1878 and 1893, and it was still getting its feet wet in 1921 and the Great Depression. In short, there is a very slow probability of a sharp slowdown in the American economy in modern times.

But what this decline in the US M2 money supply suggests is that it is very likely that the US economy will weaken in the not too distant future. If there is less capital circulating, we would expect consumers to reduce their discretionary spending. This is often a recipe for a recession.

Historically, the majority of declines in the S&P 500 have occurred after, not before, a U.S. recession takes shape.

Statistically speaking, time is an unbeaten ally for investors

With the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all hitting record closing highs in 2024, the last thing you probably want is for someone to rain on your parade with a prediction that calls for a decline potentially significant actions. Fortunately, this is a forecast that has little impact on investors with a long-term view.

One of the most glaring examples of the power of time as an ally can be seen in the business cycle.

Even if you don’t like the idea of ​​economic contractions and recessions, they are a normal and inevitable part of the boom and bust nature of the business cycle. But what’s important to recognize is that expansions and recessions are not linear (that is, they are not mirror images of each other).

While only three of America’s twelve recessions have reached the 12-month mark since the end of World War II in September 1945, almost all economic expansions have lasted several years. Two growth periods actually reached the 10-year mark. Although recessions can lead to higher unemployment and slower wage growth, these effects tend to be short-lived.

You can also see this same non-linear variance between bear and bull markets on Wall Street.

Nearly a year ago, analysts at Bespoke Investment Group released a dataset on X that examined the duration of S&P 500 bear and bull markets dating back to the start of the Great Depression. What Bespoke found is that the average S&P 500 bull market lasted about 3.5 times longer than a typical bear market over a 94-year period: 1,011 calendar days (bull market) versus 286 days calendar (bear market).

Additionally, there have been 13 distinct S&P 500 bull markets that lasted longer than the longest S&P 500 bear market since the start of the Great Depression.

Want more proof that time is an unconquered ally for patient investors?

Earlier this year, Crestmont Research updated its data from a report analyzing rolling 20-year total returns, including dividends paid, of the S&P 500 dating back to 1900. Although the S&P has not officially come into existence that in 1923 its components (and their total returns) could be found in other major indices prior to 1923 – hence the possibility of tracing total returns over 20 rolling years back to 1900.

Analysts at Crestmont Research found that the 105 rolling 20-year periods they examined (1919-2023) produced a positive average annualized return. Simply put, if you had hypothetically purchased an S&P 500 tracking index at some point since 1900 and held that position for 20 years, including dividends, you would have made money every time.

No matter what Wall Street has in store for investors in the coming months, patient investors have the luxury of having an undefeated ally on their side.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the securities mentioned. The Motley Fool has a disclosure policy.

The U.S. money supply is doing something so rare it hasn’t happened since the Great Depression — and a big move in stocks could be coming was originally published by The Motley Fool