The Fed increased the money supply hugely due to COVID, exacerbating an already underway upleg in the M2 to GDP ratio depicted in this week’s chart. The cool thing about this ratio is that it tells us about a year in advance of what’s coming up in the stock market. It does so imperfectly, but it’s still a useful message to listen to. And now that ratio is falling faster than ever, so we’re going to find out what that means.
As the economy expands, more currency is needed to lubricate all financial transactions that take place. So if the size of the money supply is growing at the same rate as GDP, then there is no imbalance. However, if the Fed is increasing the money supply faster than economic growth, then there is excess currency that needs a mission. So that money is looking for a job, and it tends to find gainful employment, which drives up stock prices. But the key is that there is currently a delay of about 1 year in this relationship.
It used to be a casual relationship in the 1960s and 1970s and so brokers would gather around the Quotrek machines each week when the news broke about what the M1 and M2 were doing. By the 1980s it had changed from a casual relationship to one dating back about 6 months. And now, in the 21st century, the lag time is about a year. More information about this change over time can be found here.
We are now seeing something we have never seen before in the entire history of these aggregate monetary indices, a history that dates back to 1959. M2 shrinks as the Fed seeks to unwind everything it has been doing trying to ‘help’ along the way. COVID. And GDP is still growing, so the amount of money sloshing around relative to the size of the economy is shrinking at an unprecedented rate. This is new territory and it is a grand economic experiment that the Fed is conducting. It is not clear what will happen if this M2/GDP ratio is changed downwards so quickly. We’ll all find out over the next year or so.
However, what I can say is that the stock market likes it much better when the M2/GDP ratio has spiked up. That reliably leads to a major price reaction about a year later. After the instances where the M2/GDP ratio has taken a flatter path, the S&P 500 has tended to move sideways. So if this positive correlation applies to this new, unprecedented state where the M2/GDP ratio is falling rapidly, then it means that 2023 is going to be a terrible year for stock prices. But again, this is something that has never happened before, so we can’t “know” for sure what it will mean.
