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Why M2 Expansion is Not a Good Predictor of Stock Market Crashes

This afternoon a robust discussion about M2 and monetary velocity projecting future economic growth and stock market activity began on FinTwit (Financial Twitter) this afternoon, culminating in this excellent long Tweet from Danielle DiMartino Booth:

The entire discussion gave me pause to reflect on the so-called “long term lag” which is inherent with Federal Reserve monetary policy and its impacts on markets. If one looks at the history of the Fed’s policies, it becomes quite obvious that coincidental equity market crashes do now always occur as the economy enters recession or credit tightens.

For example, the 1987 crash provides a clear indicator as M2 continued to grow throughout the period:

Overlaying that with the Fed Funds Effective Rate also provides not one leading indication of economic difficulty:

As one can see, the fight against inflation becoming a systemic problem was more important than economic growth and preserving the precious valuations of stocks during that time period. When overlaid with GDP growth of the period, the validation of the higher rates becomes even more convincing:

But does that apply in all cases? Let us review the very nasty recession of 1990-1992 (actually 1993) with a different chart replacing GDP with monetary velocity:

Velocity remained stagnant but the FFER’s decline was in reaction to a stagnation of economic growth. M2 continued to accelerate long after the recession with little change in monetary velocity. But the bigger events later in the decade would explain a more self-evident impact on policy. Now let’s drop velocity and add GDP to the mix:

GDP tanks, FFER bottoms, but M2 continues to rise in an attempt to reinflate the economy. It worked in 2002, with 9/11 being an extenuating circumstance that happened to coincide with the .com bubble bursting, but it still worked and economic expansion continued. Fast forward to the Great Financial Crisis and once again, the charts appear similar except for the depths of the economic contraction:

The next warning coincided with a massive equity market decline in 2018 but there was not crash in GDP until the pandemic:

The warning issued by the Fed’s deliberate Quantitative Tightening program (QT) and the recent duration issues causing two major banks to fail was essentially confirmed by Q4 2022’s reading of year over year monetary contraction:

What can we recognize from all of this? Growth in M2 is not a good predictor of a stock market crash and often misses the indications raised by credit conditions and monetary supply. While velocity is pegged to the bottom, current inflation rates are not attenuating yet to a degree which would allow for the end of the monetary contraction.

Until the real yield on US government bond exceeds the inflation rate for a sustained period and M2 contracts to a more normalized rate for a post-crisis era, every indicator says that a major recession will begin in Q3 at the earliest, Q4 at the latest and probably last well into early 2025.

This means we could get a knuckle grating bear market in assets of all types; bonds, commodities, and equities denominated in dollars.

Protect yourselves and avoid grating garlic until this is over.

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