U.S. Money Supply Has Done Something So Remarkable That It Hasn't Occurred Since the Great Depression -- and a Big Move in Stocks May Follow

Over the last century, no asset class has trumped stocks. While Treasury bonds, housing, and various commodities like gold and oil have had their moments to shine, nothing comes remotely close to matching the annualized-average return of stocks over very long periods.

But this doesn't mean stocks move up in a straight line.

Although the mature stock-driven Dow Jones Industrial Average (DJINDICES: ^DJI), broad-based S&P 500 (SNPINDEX: ^GSPC), and innovation-inspired Nasdaq Composite (NASDAQINDEX: ^IXIC) are firmly in a bull market, the dramatic sell-off of equities during the first-three trading sessions of August served as a reminder that sentiment can shift at the drop of a hat on Wall Street.

On one hand, there isn't a perfect predictive indicator or metric that can forecast these short-term directional moves in the Dow, S&P 500, and Nasdaq Composite with concrete accuracy. On the other hand, there are a variety of events and forecasting tools that have strongly correlated with big moves in Wall Street's three major stock indexes throughout history. It's these indicators and metrics that investors often turn to in an attempt to gain an advantage.

While there are a couple of metrics that suggest trouble may be brewing for Wall Street, including the S&P 500's Shiller price-to-earnings ratio and the New York Federal Reserve's recession probability tool, the data point with the lengthiest perfect track record of foreshadowing a big move in stocks is U.S. money supply.

U.S. M2 money supply last did this in 1933

Though there are five different measures of money supply, the two given the most credence are M1 and M2. The former is a measure of cash and coins in circulation, as well as demand deposits in a checking account. In essence, it's cash you can spend immediately.

Meanwhile, M2 factors in everything in M1 and adds in money market accounts, savings accounts, and certificates of deposit (CDs) below $100,000. This is still capital that can be spent, but it requires a bit more work to get to. It's also the metric that's been making history of late.

Typically, money supply isn't even something investors would be compelled to pay attention to. For the last nine decades, money supply has been steadily rising. An economy that's growing over the long run is going to need more capital to facilitate transactions, so this steadily incline in U.S. M2 money supply isn't a surprise.

But in the extremely remarkable instances where M2 has declined, trouble has been a given for the U.S. economy and stock market.

Based on data published monthly by the Board of Governors of the Federal Reserve, M2 peaked in April 2022 at $21.722 trillion. The newest reading, as of July 2024, shows U.S. M2 at $21.054 trillion, representing a decline of 3.07% in a little over two years. While this is well off the peak-to-trough drop of 4.74% from April 2022 through October 2023, it still marks the first sizable decline in U.S. M2 money supply since the Great Depression.

There are, however, some caveats and asterisks to the above data that should be noted to give a more complete picture of what's going on. For instance, M2 money supply is actually growing again on a year-over-year basis. Over the trailing-12-months, through July 2024, M2 has expanded by 1.4% -- and expansion is par for the course over the long run.

Furthermore, M2 skyrocketed by more than 26% on a year-over-year basis during the COVID-19 pandemic. Fiscal stimulus checks dumped money into the laps of many consumers and increased M2 faster than at any point dating back to 1870.

Although the 4.74% peak-to-trough decline from April 2022 through October 2023 may represent a simple reversion to the mean, history has been quite clear about what happens when the M2 money supply meaningfully retraces from an all-time high.

While the post above on social media platform X from Reventure Consulting CEO Nick Gerli is more than a year old, it emphasizes a key point. Namely, that year-over-year declines of 2% or greater in M2 money supply are scarce and historically associated with economic turbulence.

There have been only five occasions since 1870 when M2 dropped by at least 2% from the prior-year period: 1878, 1893, 1921, 1931 to 1933, and 2023. All four prior occurrences correlate with periods of economic depression and double-digit unemployment in the U.S.

The silver lining is that the Fed didn't exist in 1878 and 1893, and there was limited knowledge of how to fight back against fiscal and monetary challenges in the 1920s and 1930s. With the understanding of monetary policy that Fed officials have now, coupled with the fiscal policy tools at the disposal of the federal government, a depression is extremely unlikely today.

Nevertheless, the first notable drop in M2 since the Great Depression points to consumers having to reduce their discretionary spending. This tends to be a recipe for a recession.

Although the stock market doesn't mirror the performance of the U.S. economy, a downturn in economic activity would almost certainly weaken corporate earnings and weigh on valuations. Historically speaking, around two-thirds of the S&P 500's peak-to-trough losses occur after, not prior to, a recession being declared.

Patience and optimism produce the best investment results

Based on what history tells us about meaningful declines in M2 money supply, a big move lower in the Dow, S&P 500, and Nasdaq Composite, which may even result in a bear market, may await.

Though stock market corrections, bear markets, and even crashes can be scary at times and play on the heartstrings of investors -- especially newer investors, who may not have experienced a rapid pullback in equities before -- taking a step back, exercising patience, and examining the bigger picture has been a winning formula for investors since the stock market's inception.

There's no question that economic downturns and recessions can be challenging for most Americans. The unemployment rate usually rises, and wage-pricing power shifts away from workers to businesses during recessions. But these downturns tend to be short lived, which works in favor of long-term-minded investors.

Since the end of World War II in 1945, there have been a total of 12 U.S. recessions. Three-quarters of these downturns resolved in less than 12 months, with none of the remaining three surpassing 18 months.

Comparatively, there have been two economic expansions that went on to surpass the 10-year mark. Being an optimist and wagering on the U.S. economy to grow over time has been a smart move.

The thing is, what's good for the U.S. economy over the long run also tends to be good for Wall Street.

In June 2023, the analysts at Bespoke Investment Group posted a data set on X that analyzed every bear and bull market for the S&P 500 since the start of the Great Depression in September 1929. This meant adding up the calendar length of each major move higher and lower in the benchmark index over 94 years.

As you can see, the average S&P 500 bear market has only stuck around for 286 calendar days, or the equivalent of 9.5 months. Conversely, the typical S&P 500 bull market has endured for about 3.5 times as long (1,011 calendar days). To boot, 13 out of 27 bull markets hung around longer than the lengthiest S&P 500 bear market.

Ultimately, we're never going to be able to predict, with any guarantee, when stock market corrections or bear markets will begin, how long they'll last, or where the trough will be. It can be difficult for investors to accept this realization.

But we do know that, over time, the Dow Jones, S&P 500, and Nasdaq Composite eventually (key word!) put these downturns firmly in the rearview mirror. Having a long-term mindset and the proper perspective can make it easier to navigate whatever big move in stocks may be forthcoming.

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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 Has Done Something So Remarkable That It Hasn't Occurred Since the Great Depression -- and a Big Move in Stocks May Follow was originally published by The Motley Fool