Over the very long-term, no asset class has outperformed the stock market on an annualized return basis. But over shorter timelines, the performance of the iconic Dow Jones Industrial Average (^DJI 0.82%), broad-based S&P 500 (^GSPC 0.59%), and innovation-driven Nasdaq Composite (^IXIC 0.55%), is no more predictable than a roll of the dice or flip of a coin.

Since this decade began, the Dow Jones, S&P 500, and Nasdaq Composite have bounced back and forth between bull and bear markets in each successive year. Though all three major indexes are well off of their 2022 bear market lows, volatility still rules the roost on Wall Street and has investors wondering where stocks will head next.

A twenty dollar bill made into a paper airplane that's crashed and crumpled into a financial newspaper.

Image source: Getty Images.

While there’s no predictive tool or metric that can, with guaranteed accuracy, always predict short-term directional moves in the Dow, S&P 500, and Nasdaq Composite, there are select indicators and datapoints that strongly correlate with directional changes in the broader market. One such datapoint that should be raising investors’ eyebrows is U.S. money supply.

For the first time in 90 years, U.S. money supply is meaningfully contracting

Although there are five measures of U.S. money supply, M1 and M2 are the two that garner most of the attention. M1 consists of cash and coins in circulation, as well as demand deposits in a checking account. It’s money you have easy access to and can spend at a moment’s notice.

Meanwhile, M2 consists of everything in M1 and adds in savings accounts, money market accounts, and certificates of deposit (CDs) below $100,000. This is money you can still get to, but more work is required before it can be spent. It’s this latter category, M2, that’s sounding warning bells.

M2 is a monthly reported datapoint that’s unlikely to be on the radar for most investors. That’s because M2 has, with very few exceptions, steadily increased over time. A growing economy requires extra capital to facilitate transactions, so seeing M2 expand from nearly $287 billion in January 1959 to $20.73 trillion, as of October 2023, is no surprise.

US M2 Money Supply Chart

US M2 Money Supply data by YCharts.

What is shocking is when meaningful year-over-year declines in M2 money supply are observed. Since peaking in July 2022, M2 has fallen by an aggregate of 4.51%, as shown above.

Using a 2% year-over-year decline as somewhat of an arbitrary line in the sand, there have only been five instances since 1870 where M2 money supply has declined by at least 2%: 1878, 1893, 1921, 1931-1933, and over the past year and change. That’s right, the current drop in M2 is the first notable decline since the Great Depression.

On one hand, M2 money supply skyrocketed higher by an all-time record 26% on a year-over-year basis during the COVID-19 pandemic. A 4.51% drop from the July 2022 peak may represent nothing more than a reversion to the mean following a mammoth expansion.

On other hand, a steady decline in M2, coupled with an above-average U.S. inflation rate, is likely to put pressure on discretionary spending. Less available cash for transactions would be expected to coerce consumers to be more mindful of their spending. That’s typically a recipe for slower economic growth, if not a recession.

The historic precedence of the four previous declines in M2 money supply shouldn’t be overlooked, either. Keeping in mind that two of the four instances occurred prior to the creation of the Federal Reserve, and the nation’s central bank is more capable of tackling economic challenges now than it was in the 1920s and 1930s, the prior four events that saw M2 drop by at least 2% were accompanied by deflationary depressions and high unemployment rates.

The monetary and fiscal tools available to the Fed and federal government, respectively, make it unlikely that a depression would occur in modern times. Nevertheless, the takeaway is that notable declines in M2, while rare, have been accompanied by downturns in the U.S. economy.

Historically, stocks have performed poorly in the year following the official start to a recession.

“Following the money” is a potentially big problem for Wall Street

The concern for Wall Street and investors is that the first meaningful drop in M2 money supply since the Great Depression isn’t the only money-based metric that’s raising potential red flags. Following the money portends potential trouble on the horizon for the Dow Jones, S&P 500, and Nasdaq Composite.

The most telling money-based metric might just be commercial bank credit, which accounts for all loans, leases, and securities held by U.S. commercial banks. It’s reported on a weekly basis by the Board of Governors of the Federal Reserve System.

Similar to M2, commercial bank credit has sloped up and to the right for almost the entirety of the past half century. Between January 1973 and Nov. 15, 2023, commercial bank credit has grown from $567 billion to $17.23 trillion, which works out to a compound annual rate of around 7%. Since banks need to cover their costs associated with taking in deposits, seeing loans and leases outstanding grow over long periods is both normal and expected.

US Commercial Banks Bank Credit Chart

US Commercial Banks Bank Credit data by YCharts.

What’s abnormal and rare is a sizable decline in commercial bank credit. Since data reporting began in January 1973, there have only been three instances where commercial bank credit fell by 2% from its all-time high:

  • A 2.09% peak drop during the heart of the dot-com bubble in October 2001.
  • A maximum decline of 6.94% following the Great Recession in March 2010.
  • The current dip of 2.07% from the mid-February 2023 peak.

The previous two instances of a greater than 2% decline were associated with a halving in the benchmark S&P 500 and an even larger decline in the Nasdaq Composite.

What this decline in commercial bank credit clearly shows is that banks are tightening their lending standards and being stingier with where they lend their money. In short, it’s a recipe for an economic slowdown, which would bode poorly for corporate earnings amid an already pricey market.

A smiling person reading a financial newspaper while seated at a table in their home.

Image source: Getty Images.

More than a century of history suggests patience pays off handsomely on Wall Street

Although history rarely repeats on Wall Street, it has a way of rhyming. Given the notable decline in various money-based metrics, it wouldn’t be a surprise to see the Dow, S&P 500, and Nasdaq Composite dip into a bear market in 2024.

But history is a two-sided coin for investors, and it has a knack for delivering hefty rewards to those who are patient, optimistic, and opportunistic.

As much as investors might dislike recessions, they’re a perfectly normal and inevitable part of the long-term economic cycle. More importantly, they’re short-lived. Nine out of 12 U.S. recessions since the end of World War II have lasted less than a year, with none of the one dozen surpassing 18 months.

By comparison, most economic expansions have endured multiple years, with two periods extending beyond 10 years. Over long periods, the U.S. economy and corporate earnings are poised for expansion.

Even though stocks and the U.S. economy don’t move in tandem, this disproportionate optimism also translates to Wall Street.

According to a dataset published in June by investment analysis company Bespoke Investment Group, there have been 27 separate bull and bear markets for the S&P 500 since the start of the Great Depression in September 1929. Whereas the average bear market for the benchmark index has lasted just 286 calendar days (about 9.5 months), the typical bull market over the last 94 years has clocked in at 1,011 calendar days (roughly two years and nine months).

However, the best example of history and perspective working in investors’ favor might just be the dataset Crestmont Research updates on a yearly basis.

The analysts at Crestmont examined the rolling 20-year total returns (including dividends) of the S&P 500 dating back to 1900. Though the S&P didn’t come into existence until 1923, its components could be found in other major indexes prior to 1923. This made it relatively easy for analysts to back-test their calculations to 1900, which ultimately yielded 104 rolling 20-year periods (1919-2022).

The jaw-dropping takeaway from Crestmont’s rolling 20-year total returns data is that all 104 periods would have generated a profit for investors. Regardless of whether you, hypothetically, purchased at a temporary peak or were lucky enough to buy an S&P 500 tracking index during a bear market, you’d have made money as long as you held your position for 20 years.

No matter what’s to come for Wall Street — even if it is a big move lower for stocks in the short-term — a long-term, optimistic, and opportunistic investor mindset is, historically, a virtually foolproof moneymaking strategy.

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