U.S. Money Supply Is Making History for the First Time Since the Great

Over lengthy periods, it’s tough to outpace equities in the return column. Compared to gold, oil, housing, and Treasury bonds, the annualized return of stocks trumps them all over the long run.

However, the predictability of directional moves in the Dow Jones Industrial Average (^DJI 0.23%), S&P 500 (^GSPC 0.80%), and Nasdaq Composite (^IXIC 1.14%) gets thrown out the window when the time frame is narrowed. Since the start of 2020, these three indexes have traded off bear and bull markets in successive years.

Image source: Getty Images.

Even though forecasting directional moves for the major indexes can’t be done with 100% accuracy, it doesn’t stop investors from trying to gain an edge. This is where a very select group of economic data points and predictive indicators comes into play. Though Wall Street offers no short-term guarantees, a couple of data points and indicators do have exceptional track records of correlating with moves higher or lower in the broader market.

One such data point that speaks volumes at the moment is U.S. money supply.

U.S. money supply hasn’t done this since 1933

Among the five money supply measures, two receive the bulk of the attention from economists and investors: M1 and M2. M1 factors in all the cash and coins in circulation, as well as demand deposits in a checking account. Think of M1 as cash that’s easily accessible and can be spent in the blink of an eye.

Meanwhile, M2 takes into account everything in M1 and adds in savings accounts, money market accounts, and certificates of deposit (CDs) below $100,000. M2 is still factoring in cash that consumers can spend, but it’s adding in capital that takes a bit more effort to get to. It’s this figure, M2, that is causing alarm in the investing world.

For well over a century, U.S. money supply has been rising with little interruption. Since a growing economy requires more cash and coins in circulation to complete transactions, rising money supply is something economists and investors tend to take for granted and assume is a given.

But on rare occasions, U.S. money supply contracts in a big way — and that’s historically portended bad news for the U.S. economy and stock market.

US M2 Money Supply data by YCharts.

In July 2022, U.S. M2 money supply peaked at an all-time high of roughly $21.7 trillion. Based on the Feb. 27 data release from the Board of Governors of the Federal Reserve, M2 stood at $20.78 trillion, as of January 2024. All told, we’re looking at a year-over-year drop of 1.44% and an aggregate decline from the July 2022 peak of 4.21%. This is the first significant drop in M2 since the Great Depression.

The caveat to the decline since July 2022 is that M2 expanded at a truly historic pace during the COVID-19 pandemic. Fiscal stimulus increased M2 by a record 26% on a year-over-year basis. Thus, a case could be made that a 4.21% retracement is merely a reversion to the mean. Then again, history has been incredibly unforgiving when M2 money supply has fallen by at least 2% on a year-over-year basis.

According to research conducted by Reventure Consulting CEO Nick Gerli, which relied on data from the U.S. Census Bureau and the Federal Reserve, there have only been five instances, when back-tested to 1870, where M2 has declined by at least 2%: 1878, 1893, 1921, 1931-1933, and July 2022 through at least January 2024. The previous four instances all coincided with deflationary depressions and double-digit unemployment rates.

WARNING: the Money Supply is officially contracting. ????

This has only happened 4 previous times in last 150 years.

Each time a Depression with double-digit unemployment rates followed. ???? pic.twitter.com/j3FE532oac

— Nick Gerli (@nickgerli1) March 8, 2023

If I can offer a ray of hope, two of the four previous incidences occurred prior to the creation of the nation’s central bank, and the other two date back more than nine decades. The Federal Reserve’s knowledge of monetary policy, and the fiscal tools available to the federal government, make it highly unlikely that a depression would materialize today.

On the flip side, declining money supply isn’t something that should be swept under the rug. If the core inflation rate remains above the Fed’s 2% long-term target and M2 continues to decline, there will be less discretionary income to go around.

Based on data from Bank of America Global Research, about two-thirds of the S&P 500’s max drawdowns occur after, not prior to, a U.S. recession being declared. In short, a persistent decline in M2 money supply could spell trouble for a currently red-hot stock market.

Following the money has been a problem for the past year

The worry for investors is that M2 represents just one money metric that looks to be working against the U.S. economy and stocks, as a whole. Another key money-based data point that’s cause for concern is commercial bank credit.

Commercial bank credit is reported by the Board of Governors of the Federal Reserve on a…