For the past 16 months, professional and everyday investors alike have been taken for quite the ride. The ageless Dow Jones Industrial Average (^DJI), broad-based S&P 500 (^GSPC), and growth-driven Nasdaq Composite (^IXIC) all entered respective bear markets and produced their worst full-year returns (in 2022) since the Great Recession.
Even though stock market corrections, and to some extent bear markets, are a common occurrence on Wall Street, these events still have a tendency to incite fear and panic among investors. More specifically, they leave everyday investors wondering when the bear market downturn will end.
To be crystal clear, there isn't a metric, indicator, or tool that can predict with concrete accuracy when a bear market will begin, how long it'll last, or how steep the decline will be. There are, however, plenty of tools we can use to swing the odds in our favor as investors so we know what to expect moving forward.
One of those tools is the U.S. money supply, which is portending something big for the stock market.
M2 money supply hasn't done this since 1933, and investors should take note
Though there are a couple of money supply measures, the two most investors and economists focus on are M1 and M2. M1 factors in the cash and coins currently in circulation, along with things like traveler's checks. It's easily accessible money that can be spent immediately. Meanwhile, M2 takes into account everything in M1, as well as savings accounts, money market funds, and certificates of deposit (CD) of less than $100,000. In other words, it's money people can get to, but it takes a little extra work.
As you can see in the tweet from Charles Schwab Chief Investment Strategist Liz Ann Sonders, U.S. M2 money supply through March has fallen 4.1% on a year-over-year basis.
Declining money supply in combination with above-average inflation is generally bad news for the U.S. economy. If the cost for goods and services keeps climbing at an above-average pace, and there are fewer dollars and coins in circulation to pay for these goods and services, something typically breaks, leading to a period of deflation and an economic downturn.
But Sonders isn't the first, nor will she be the last, to call out this historic decline in U.S. money supply.
Less than two months ago, Reventure Consulting founder and CEO Nick Gerli leaned on historic M2 and U.S. inflation rate data from the Federal Reserve Bank of St. Louis and U.S. Census Bureau to paint a picture of U.S. money supply growth and contraction dating all the way back to 1870. This is represented in the tweet you see here.
Keeping in mind that Gerli's tweet is nearly two months old and the 2% decline that's represented as “right now” is currently 4.1%, we can see that this is the first decline in M2 money supply in 90 years. With the exception of the Great Depression, it's the second-steepest decline in M2 money supply in more than 150 years of history.
Gerli notes that the previous four instances of M2 contraction led to three depressions (1870s, 1921, and the Great Depression) and one panic (1893), along with correlative spikes in the U.S. unemployment rate.
Before I go any further, let me remind you that the 1870s depression and panic in 1893 occurred before the creation of the Federal Reserve. Given the tools and knowledge the nation's central bank has after more than a century in existence, a depression is highly unlikely today.
M2 portends a recession: Here's why that matters for investors
The big takeaway of only the fifth decline in M2 money supply since 1870 is that there's an increased likelihood a U.S. recession is taking shape in the not-too-distant future.
Although the Dow Jones, S&P 500, and Nasdaq Composite don't mirror the ups and downs of the U.S. economy, no bear market after World War II has bottomed out before an official recession was declared by the eight-economist panel of the National Bureau of Economic Research. In other words, if (the big “if”) we're headed toward a recession, the expectation would be that stocks haven't yet seen their bear market lows.
Furthermore, data from Bank of America Research shows that two-thirds of the peak-to-trough drawdowns in the S&P 500 since 1929 have occurred during a recession and not prior to one being declared. It's a bit more fuel for the fire that the stock market lows probably haven't been reached.
Looking beyond M2, there are a couple of clues that economic weakness may be brewing.
Perhaps the biggest “clue” can be found in the minutes of the Federal Open Market Committee's March meeting. The 12-member body that oversees our nation's monetary policy notes that a mild recession is baked into their outlook for later this year. It pretty much doesn't get more direct than that.
In addition to FOMC commentary, the Federal Reserve Bank of New York's recession probability indicator offers pretty compelling evidence that a recession may be coming.
The NY Fed's tool analyzes the spread (difference in yield) between the three-month and 10-year Treasury bond. When the yield curve inverts, it's sometimes an ominous sign for the economy and Wall Street. The current yield-curve inversion between the three-month and 10-year note is the largest since 1981. Not surprisingly, the NY Fed is forecasting a 57.77% chance of a recession over the next 12 months. That's the highest probability of a recession in more than four decades.
This is the closest you'll ever get to a guarantee on Wall Street
All in all, M2 isn't painting the prettiest picture for Wall Street over the very short term. But there's a really, really big difference between what happens to the Dow, S&P 500, and Nasdaq, over the next six-to-12 months and where these indexes will be 10 or 20 years from now.
According to sell-side consultancy firm Yardeni Research, there have been 39 separate double-digit percentage declines in the benchmark S&P 500 since the start of 1950. That's one correction, on average, every 1.87 years. Excluding the current bear market, every single previous decline — be it a correction, bear market, or crash — was eventually recouped by a bull market.
An even more compelling case can be made courtesy of data from market analytics company Crestmont Research. I rely on Crestmont's dataset often because it shows how powerful time can be as an ally. It also provides the closest thing you're ever going to get to a guarantee on Wall Street.
What Crestmont did was look at every 20-year rolling investment period in the S&P 500, beginning in 1900. It analyzed what an investor would have generated in hypothetical returns, including dividend payments, if they purchased an S&P 500 tracking index and held that position for 20 years. With a start year of 1900, this left Crestmont with 104 ending years of data (1919 through 2022).
The result? All 104 years led to a positive total return. Datasets don't get more compelling than 104 out of 104!
Furthermore, most investors cleaned up by simply being patient. The total returns, which are reported on an annualized basis, were around 5% or below just a handful of the 104 years. Comparatively, approximately 40% of the 104 end years produced an annualized total return ranging from 10.8% to 17.1%.
Sure, the next couple of quarters could be bumpy if history repeats itself. But if you have the luxury of using time as an ally, big drops in the stock market are blessings in disguise.
Originally published on Fool.com
Charles Schwab and Bank of America are advertising partners of The Ascent, a Motley Fool company. Sean Williams has positions in Bank of America. The Motley Fool has positions in and recommends Bank of America. The Motley Fool recommends Charles Schwab. The Motley Fool has a disclosure policy.
