U.S. Money Supply Is Doing Something So Scarce That It Hasn’t Happened Since the Great Depression — and a Big Move in Stocks May Be Forthcoming

Over long stretches, Wall Street has demonstrated that it’s a wealth-creating powerhouse. Compared to other asset classes, including gold, oil, housing, and Treasury bonds, stocks have handily outperformed on an annualized return basis over the last century.

But when the lens is narrowed to just a few months or a couple of years, the performance of the broad-market indexes becomes much tougher to forecast. In fact, the ageless Dow Jones Industrial Average (DJINDICES: ^DJI), benchmark S&P 500 (SNPINDEX: ^GSPC), and growth stock-powered Nasdaq Composite (NASDAQINDEX: ^IXIC) traded off bear and bull markets in successive years for the first four years of this decade.

When the stock market is volatile, it’s only natural for investors to seek out clues that might signal which direction stocks will head next. While there’s no such thing as a predictive indicator or metric that can, with concrete accuracy, forecast where the major stock indexes are headed, it doesn’t stop investors from trying to gain an advantage.

However, there are a small number of indicators that have strongly correlated with historic moves higher or lower in the Dow, S&P 500, and Nasdaq Composite.

One such predictive tool, which hasn’t signaled the warning we’re seeing now since the Great Depression, appears to portend trouble for the U.S. economy and a big move to come for stocks.

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

The forecasting metric I’ve alluded to above is the U.S. money supply. Though the U.S. money supply has five different measures, the two with the most merit tend to be M1 and M2.

M1 money supply takes into account cash and coins in circulation, as well as demand deposits in a checking account. Think of it as money that’s very accessible and can be spent at the drop of a hat. Meanwhile, M2 factors in everything in M1 and adds in savings accounts, money market accounts, and certificates of deposit (CDs) under $100,000. It’s still money that’s accessible, but it takes a bit more work to get to and spend. It’s this category, M2 money supply, which is cause for concern.

Normally, little attention is paid to M2 money supply. That’s because it’s been rising with virtually no interruption for the last nine decades. With the U.S. economy growing over time, it’s not surprising that more capital has been needed to facilitate transactions.

What’s abnormal is a decline in the U.S. money supply — which is exactly what we’re witnessing right now with M2.

In April 2022, the Board of Governors of the Federal Reserve reported that M2 peaked at an all-time high of $21.722 trillion. For some context, that’s up from $286.6 billion in January 1959 and represents a compound annual growth rate of approximately 7%. But as of April 2024, M2 came in at $20.867 trillion, representing a decline of nearly $855 billion — 3.94% on a percentage basis — in two years. It’s the first time M2 money supply has backed off more than 2% from its all-time high since the Great Depression.

The stipulation to this decline that shouldn’t be overlooked is that M2 exploded higher by 26% on a year-over-year basis during 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. An argument can be made that the nearly 4% retracement in M2 over the last two years is nothing more than a normalization after a historic expansion.

I’ll also point out that M2 has actually risen on a year-over-year basis. Despite being down 3.94% from its all-time high in April 2022, M2 is higher by a very modest 0.14% from where things stood one year ago.

Nevertheless, history has been quite clear about what happens anytime the M2 money supply retraces by at least 2% from its high — and it’s not good news for Wall Street or the U.S. economy.

As you can see in the post above from Reventure Consulting CEO Nick Gerli on social media platform X (formerly Twitter), year-over-year drops of at least 2% in M2 are quite scarce. Using data from the Federal Reserve and U.S. Census Bureau, Gerli was able to back-test these percentage changes in U.S. money supply since 1870. Over this span, just five instances were noted where M2 declined by at least 2% on a year-over-year basis: 1878, 1893, 1921, 1931-1933, and 2023.

All four previous instances of M2 dropping by 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 federal government are far more knowledgeable now about how to tackle economic turbulence than they were a century ago. The Fed didn’t exist during the depressions of 1878 and 1893, and it was still getting its proverbial feet wet in 1921 and during the Great Depression. In short, there’s a very low probability of a steep downturn in the U.S. economy in modern times.

But what this decline in U.S. M2 money supply does suggest is a good likelihood of the U.S. economy weakening in the not-too-distant future. If there’s less capital in circulation, the expectation would be for consumers to pare back their discretionary spending. That’s often a recipe for a recession.

Historically speaking, the bulk of the S&P 500’s downturns have occurred after, not prior to, a U.S. recession taking shape.

Statistically speaking, time is an undefeated ally for investors

With the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all roaring to record-closing highs in 2024, the last thing you probably want is someone raining on your parade with a prognostication that calls for potentially meaningful downside to come in stocks. Thankfully, this is a forecast with little bearing on investors with a long-term mindset.

One of the most glaring examples of time being a powerful ally can be seen in the economic cycle.

As much as you might dislike the idea of economic contractions and recessions, they’re a normal and unavoidable part of the boom-and-bust nature of the economic cycle. But what’s important to recognize is that booms and busts aren’t linear (i.e., they aren’t mirror images of one another).

Whereas only three out of 12 U.S. recessions have reached the 12-month mark since World War II ended in September 1945, almost every economic expansion has endured multiple years. Two periods of growth actually hit the 10-year mark. While recessions can cause unemployment to rise and wage growth to slow, these effects tend to be short-lived.

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

Nearly one year ago, the analysts at Bespoke Investment Group published a data set on X that examined the length of bear and bull markets for the S&P 500 dating back to the start of the Great Depression. What Bespoke found was that the average S&P 500 bull market lasted roughly 3.5 times longer than the typical bear market over a 94-year stretch: 1,011 calendar days (bull market) versus 286 calendar days (bear market).

Furthermore, there have been 13 separate S&P 500 bull markets that endured longer than the lengthiest S&P 500 bear market since the Great Depression began.

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

Earlier this year, Crestmont Research refreshed its data set from a report that analyzed the rolling 20-year total returns, including dividends paid, of the S&P 500 dating back to 1900. Even though the S&P didn’t officially come into existence until 1923, its components (and their total returns) could be found in other major indexes prior to 1923 — thus, the ability to trace rolling 20-year total returns back to 1900.

The analysts at Crestmont Research found that all 105 rolling 20-year periods they examined (1919-2023) produced a positive annualized average return. In simple terms, if you, hypothetically, purchased an S&P 500 tracking index at any point since 1900 and held that position for 20 years, including dividends, you’d have made money every single time.

No matter what Wall Street has in store for investors over the coming months, patient investors have the luxury of time as an undefeated ally in their corner.

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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 stocks mentioned. The Motley Fool has a disclosure policy.

U.S. Money Supply Is Doing Something So Scarce That It Hasn’t Happened Since the Great Depression — and a Big Move in Stocks May Be Forthcoming was originally published by The Motley Fool

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