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The US money supply recently did something it hasn’t done since the Great Depression – and it could spell trouble for Wall Street.

Posted on by L. Dreeye
The US money supply recently did something it hasn’t done since the Great Depression – and it could spell trouble for Wall Street.

A historic shift in the money supply, not seen in 90 years, could spell trouble for stocks.

On October 12, Wall Street celebrated the two-year anniversary of the current bull market. Optimism among investors was evident given the ageless Dow Jones Industrial Average (^DJI 0.69%)landmark S&P 500 Index (^ GSPC 0.41%)and growth Nasdaq Composite (^IXIC 0.80%) reaching several record highs.

But if history has taught us anything, it’s that stock market corrections and bear markets are normal and inevitable. While no predictive metric is 100% accurate in predicting downward moves in the Dow Jones, S&P 500 and Nasdaq Composite, there are a small number of events and data points that have strongly has been correlated with stock weakness throughout history. It is these events and data that investors sometimes look to to gain an edge.

One of these highly correlated forecasting metrics, which has an unblemished track record of predicting economic downturns in the US stretching back more than 150 years, spells trouble for Wall Street.

A paper airplane containing a twenty-dollar bill crashed and crashed into the business section of the newspaper.

Image source: Getty Images.

The US M2 money supply has not done this since 1933.

The one forecasting tool that should raise eyebrows in the investment community is the US money supply.

Although there are several ways to measure the money supply, the most suitable are M1 and M2. M1 accounts for all cash and coins in circulation, travelers checks, and demand deposits held in a checking account. This is money that consumers can spend at any time.

M2, on the other hand, takes everything in M1 and adds savings accounts, money market accounts, and certificates of deposit (CDs) under $100,000. Consumers can still access this money, but it requires more time and effort to obtain it before it can be spent. It is this indicator of the money supply that raises alarming signals.

Economists have more or less ignored the M2 money supply for the vast majority of the last 90 years as it has continually expanded. A steadily growing economy needs more capital in circulation to facilitate transactions.

But on those very rare occasions in history when there has been a noticeable decline in the M2 money supply, it has created problems for the US economy and Wall Street.

US M2 money supply chart

US M2 money supply; YCharts data.

M2 is reported monthly by the Board of Governors of the Federal Reserve System. In April 2022, it reached a record high of $21.723 trillion. But between April 2022 and October 2023, the US M2 money supply will contract by 4.74% from this all-time high.

This marked the first fall in the M2 money supply of at least 2% from its all-time high, as well as the first annual decline of at least 2% since the Great Depression.

Before you dig any deeper, keep in mind that there are two caveats to this significant decline in the M2 money supply.

First, M2 is growing again. Based on September 2024 data of $21.221 trillion, M2 grew 2.7% year over year, which would generally be good news for the US economy. Collectively, M2 is still 2.31% below its all-time high.

Second, this sharp fall in the US M2 money supply follows a historic annual growth rate of over 26% at the height of the pandemic. Fiscal stimulus and historically low interest rates have flooded the US economy with capital. In other words, it is quite possible that this first decline in M2 in 90 years is a favorable mean reversion following a previously unprecedented expansion of the money supply.

However, more than a century of history suggests that this decline may have more sinister consequences.

In March 2023, Nick Gurley, CEO of Reventure Consulting, posted the message you see above on social network X (formerly known as Twitter). Using data from the Federal Reserve and the US Census Bureau, Gurley was able to test the growth and contraction of M2 over more than 150 years.

Although this post is over a year old, it highlights key correlations between the rare year-on-year decline in the US M2 money supply and the serious weakness of the US economy.

Since 1870, there have only been five occasions when M2 fell by at least 2% year on year: 1878, 1893, 1921, 1931-1933 and 2023. All four previous cases are correlated with US depression and dual depression. -significant unemployment rate.

Again, there is a caveat to this data. In particular, the Federal Reserve System did not exist in 1878 or 1893, and the tools and knowledge of fiscal and monetary policy available today far exceed what was known and understood in 1921 and during the Great Depression. In short, there will be a depression in the US incredible unlikely to happen in modern times.

However, M2’s largest peak-to-trough decline since the Great Depression signals that consumers will have to cut back on their discretionary spending. Traditionally, this is a key factor in economic downturns.

Based on research from Bank of AmericaAbout two-thirds of the S&P 500’s peak-to-trough declines occur after, rather than before, a recession is declared.

A businessman critically reads a financial newspaper.

Image source: Getty Images.

Time is an invincible ally of investors

But while history portends trouble for Wall Street in the coming quarters, time continues to be an undeniable ally for investors willing to take a step back and look to the horizon.

As much as workers and investors love economic downturns, they, like stock market corrections and bear markets, are an inevitable part of the business cycle. However, it is important to recognize that booms and busts within the business cycle are not mirror images of each other.

Since the end of World War II in September 1945, the US economy has gone through a dozen recessions. Of those 12 recessions, nine resolved in less than a year, and the remaining three ended in 18 months or less.

At the other end of the spectrum, the vast majority of economic growth continued for several years, including two periods of growth that exceeded the 10-year mark. Investors betting on the U.S. economy to grow over the long term have been richly rewardedā€”and the same can be said for those betting on the stock market to grow over time.

In June 2023, shortly after the S&P 500 was confirmed to be in a bull market following the 2022 bear market low, researchers at Bespoke Investment Group published the report you see above at X. Bespoke calculated the calendar day length of each bear market and the S&P 500 bull market dating back to the start of the Great Depression in September 1929.

The Bespoke data set showed that the average S&P 500 bear market lasts only 286 calendar days, or approximately 9.5 months. By comparison, the typical 94-year S&P 500 bull market lasted 1,011 calendar days, or about 3.5 times longer than the average bear market.

Additionally, 14 of the 27 bull markets, including the current one, lasted longer than the longest S&P 500 bear market ever.

Regardless of the sophisticated software you use or the historical data you rely on, you will never be able to accurately determine which direction the Dow, S&P 500 and Nasdaq Composite will move in the short term.

But history makes it abundantly clear that the major Wall Street indexes and the stock market’s most influential companies will rise in value over time. When time works its magic, even the most frightening historical data seems harmless.