On Oct. 12, Wall Street celebrated the two-year anniversary of the current bull market. Optimism among investors has been readily apparent, with the ageless Dow Jones Industrial Average(DJINDICES: ^DJI), benchmark S&P 500(SNPINDEX: ^GSPC), and growth-powered Nasdaq Composite(NASDAQINDEX: ^IXIC) reaching multiple all-time highs.
But if history has taught us anything, it’s that stock market corrections and bear markets are normal and inevitable. Although no predictive metric is 100% accurate in forecasting directional moves lower in the Dow Jones, S&P 500, and Nasdaq Composite, there are a small number of events and data points that have strongly correlated with weakness in stocks throughout history. These events and data points are the ones that investors sometimes look to in order to gain an advantage.
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One of these highly correlative forecasting metrics, which has an immaculate history of predicting U.S. economic downturns dating back more than 150 years, is foreshadowing trouble for Wall Street.
Image source: Getty Images.
The one predictive tool that should be raising eyebrows within the investment community is U.S. money supply.
While there are a number of ways to measure money supply, the two with the greatest relevance are M1 and M2. M1 factors in all cash and coins in circulation, travelers’ checks, and demand deposits found in a checking account. This is money that can be spent by consumers at a moment’s notice.
On the other hand, M2 takes everything found in M1 and adds in savings accounts, money market accounts, and certificates of deposit (CDs) under $100,000. This is still money consumers can access, but it requires more time and effort to get to before it can be spent. It’s this measure of money supply that is raising red flags.
Economists more or less ignored M2 money supply for the overwhelming majority of the last 90 years because it had been expanding without fail. A steadily growing economy needs more capital in circulation to facilitate transactions.
But in those very rare instances throughout history where notable declines in M2 money supply have occurred, it has spelled trouble for the U.S. economy and Wall Street.
US M2 Money Supply Chart
M2 is reported monthly by the Board of Governors of the Federal Reserve System. In April 2022, it hit an all-time high of $21.723 trillion. But between April 2022 and October 2023, U.S. M2 money supply would decline by a peak of 4.74% from this record high.
This marked the first drop-off of at least 2% in M2 money supply from an all-time high, as well as the first year-over-year decline of at least 2%, since the Great Depression.
Before digging any deeper, be aware that there are two caveats to this meaningful decline in M2 money supply.
First, M2 is once again climbing. Based on the September 2024 reading of $21.221 trillion, M2 has risen by 2.7% on a year-over-year basis, which would generally be good news for the U.S. economy. In aggregate, M2 is still 2.31% below its all-time high.
Second, this peak-to-trough drop in U.S. M2 money supply followed a historic year-over-year expansion of more than 26% during the height of the pandemic. Fiscal stimulus and historically low interest rates flooded the U.S. economy with capital. In other words, it’s possible this first-in-90-years decline in M2 is a benign reversion to the mean following a never-before-seen expansion of the money supply.
However, more than a century of history suggests this decline may have more ominous implications.
In March 2023, Nick Gerli, the CEO of Reventure Consulting, released the post you see above on the social media platform X (formerly known as Twitter). Using data from the Federal Reserve and U.S. Census Bureau, Gerli was able to back-test M2 growth and contraction over more than 150 years.
Although this post is more than a year old, it highlights key correlations between rare year-over-year declines in U.S. M2 money supply and big-time weakness in the U.S. economy.
Since 1870, there have been only five instances where M2 fell by at least 2% on a year-over-year basis: 1878, 1893, 1921, 1931-1933, and 2023. All four prior occurrences correlate with a U.S. depression and double-digit unemployment rate.
Once again, there is a caveat to this data. Specifically, the Federal Reserve didn’t exist in 1878 or 1893, and the fiscal and monetary-policy tools and knowledge available today far exceeds what was known and understood in 1921 and during the Great Depression. In short, a U.S. depression would be incredibly unlikely to occur in modern times.
Nevertheless, the biggest peak-to-trough decline in M2 since the Great Depression signals the possibility of consumers having to reduce their discretionary spending. Traditionally, this is a key ingredient for an economic downturn.
Based on research from Bank of America, roughly two-thirds of the S&P 500’s peak-to-trough downturns occur after, not prior to, a recession being declared.
Image source: Getty Images.
But while history foreshadows trouble for Wall Street in the quarters to come, time continues to be an undeniable ally of investors willing to take a step back and look to the horizon.
As much as workers and investors might dislike economic downturns, they are — just like stock market corrections and bear markets — an inevitable part of the economic cycle. Yet what’s important to recognize is that upswings and downturns within the economic cycle aren’t mirror images of each other.
Since the end of World War II in September 1945, the U.S. economy has navigated its way through a dozen recessions. Out of these 12 recessions, nine resolved in less than a year, and the remaining three wrapped up in 18 months or less.
On the other end of the spectrum, the overwhelming majority of economic expansions stuck around for multiple years, including two periods of growth that surpassed the 10-year mark. Investors counting on the U.S. economy to expand over the long run have been handsomely rewarded — and the same can be said for those who are wagering on the stock market to head higher over time.
In June 2023, shortly after the S&P 500 was confirmed to be in a bull market following its 2022 bear market low, the researchers at Bespoke Investment Group released the post you see above on X. Bespoke calculated the calendar-day length of every bear and bull market in the S&P 500 dating back to the start of the Great Depression in September 1929.
Bespoke’s data set found the average S&P 500 bear market lasts just 286 calendar days, or roughly 9.5 months. Comparatively, the typical S&P 500 bull market over 94 years endured for 1,011 calendar days, or approximately 3.5 times longer than the average bear market.
To boot, 14 of the 27 bull markets — including the current one — have lasted longer than the lengthiest S&P 500 bear market on record.
Regardless of the sophisticated software you use or the historic data points you rely on, you’ll never be able to concretely determine which direction the Dow, S&P 500, and Nasdaq Composite will head over the short term.
But history is quite clear that Wall Street’s major indexes, and the stock market’s most-influential businesses, will increase in value over time. Allowing time to work its magic makes even the most frightening of historic data points appear benign.
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Bank of America is an advertising partner 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 has a disclosure policy.
