This week’s featured indicator focuses on money supply. In simple terms, money supply is all of the currency and other cash-like things that are out and about in a country’s economy. In this particular case, we are focused on what is called M2 money supply. That consists of the currency and coins held by the public as well as savings accounts, checking accounts, money markets, and small CDs. It is basically a measure of the forms of money that can be readily spent.
When it comes to its impact on the financial market, we have found one of the most important aspects to be the annual change in the real money supply (this is simply money supply growth minus inflation) shown on the above chart. It compares the performance of the Dow Jones Industrial Average to Real M2 Growth going all the way back to 1915. When the supply of money is growing at 6-7% or higher per year, it means that there is more cash circulating in the economy, or what we would call lots of liquidity. In times of high liquidity, much of this excess cash tends to find its way into financial assets, and that tends to push the prices of those assets higher.
We can also see the opposite effect on the chart. When the real money supply is growing at less than about 1.5%, the stock market has basically gone nowhere.
The importance of this indicator has been on display over the past year as the Federal Reserve injected liquidity into the financial system at a rapid pace to help stabilize asset prices and the economy. The result was a 23.7% increase in the real M2 money supply, the most since WWII.
The bottom line: Money moves markets! Measures of liquidity such as this one will always be important to assessing risks in financial markets.
Indicator Insights is a weekly feature on our blog where we highlight various financial market metrics and explain what they are and why they matter. Our risk aware investing process uses hundreds of these individual indicators, taking a weight of evidence approach in making asset allocation decisions.
This is intended for informational purposes only and should not be used as the primary basis for an investment decision. Consult an advisor for your personal situation.
Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.
Past performance does not guarantee future results.