For more than two years, the bulls have been running wild on Wall Street. In 2024, the ageless Dow Jones Industrial Average(DJINDICES: ^DJI), broad-based S&P 500(SNPINDEX: ^GSPC), and innovation-fueled Nasdaq Composite(NASDAQINDEX: ^IXIC) respectively rallied by 13%, 23%, and 29%, with everything from the artificial intelligence (AI) revolution to Donald Trump's November victory stoking optimism.
But the stock market wouldn't be a market without equities moving in both directions.
Both professional and everyday investors are regularly on the lookout for clues that may point to shifts in the Dow Jones, S&P 500, and Nasdaq Composite. Even though no Holy Grail data point or predictive metric exists that can, with 100% accuracy, forecast short-term directional moves in Wall Street's major indexes, there are select indicators that have strongly correlated with moves higher or lower in the Dow, S&P 500, and Nasdaq throughout history.
While historically high stock valuations may be the most advertised concern for Wall Street, another economic data point, which recently did something not witnessed in nine decades, is what should be raising investors' eyebrows.
Image source: Getty Images.
This hadn't happened to U.S. money supply in 90 years
The correlative metric that brings Wall Street's two-year bull market rally into question is U.S. money supply.
Although there are five measures of U.S. money supply, two tend to be more closely monitored than the others: M1 and M2. The former is a measure of cash and coins in circulation, as well as demand deposits in a checking account. It's essentially money that can be spent at a moment's notice.
Meanwhile, M2 adds in everything from M1 and factors in money market accounts, savings accounts, and certificates of deposit (CDs) below $100,000. This, too, is money that consumers can spend, but it takes more effort to get their hands on. It's also the specific money supply measure that's made a historic move.
Normally, economists gloss over the monthly reported M2 figure because it's been moving higher with virtually no interruption for decades. The logic here is that a growing economy needs more capital in circulation over time to facilitate an increasing number of transactions.
But in those exceptionally rare instances throughout history where M2 has had a notable decline from an all-time high, it's led to a dicey period for the U.S. economy and stock market.
According to the latest report from the Board of Governors of the Federal Reserve, M2 totaled $21.534 trillion in December 2024. This represents a drop-off of $189 billion, or 0.87%, from the record high of $21.723 trillion in April 2022.
The eyebrow raiser is that U.S. M2 money supply tumbled by $1.06 trillion between April 2022 and October 2023, which equates to a decline of 4.74%. This marked the first time since the Great Depression that M2 dropped by at least 2% on a year-over-year basis.
Though I'll address the correlative implications of this historic drop-off in M2 in a moment, it's important to add two qualifiers to this peak-to-trough decline. First off, M2 money supply jumped by more than 26% on a year-over-year basis during the height of the COVID-19 pandemic due to a never-before-seen level of fiscal stimulus. Thus, an argument can be made that the 4.74% decline in M2 is nothing more than a normal retracement following a historic expansion of the U.S. money supply.
The other asterisk to consider is that M2 has risen by 3.9% over the trailing year. A steadily climbing money supply is often indicative of a healthy U.S. economy.
With the above qualifiers in mind, the chart you see above comes courtesy of Reventure Consulting CEO Nick Gerli. Even though it was posted on social media platform X almost two years ago, it clearly demonstrates the correlation between notable declines in U.S. M2 money supply and the U.S. economy when back-tested more than 150 years.
Since the start of 1870, there have been five instances where M2 money supply has declined by at least 2% on a year-over-year basis: 1878, 1893, 1921, 1931-1933, and 2023. The prior four occurrences all correlate with periods of double-digit unemployment and an economic depression.
To be fair, things were a lot different in the late 19th and early 20th centuries. The Federal Reserve didn't exist until December 1913, and the tools used to combat economic downturns are far more advanced today than they were during the Great Depression. All of this is to say that a depression, while not impossible, is highly unlikely to occur in modern times.
But what this first-in-90-years shift in M2 does point to is the possibility of consumers paring back their discretionary spending. If consumers choose to forego certain purchases, it may be a recipe for a recession.
According to a study by Bank of America Global Research, approximately two-thirds of the S&P 500's peak-to-trough declines between 1927 and March 2023 occurred after recessions were declared.
Image source: Getty Images.
Perspective changes everything on Wall Street -- often for the better
Based on what 155 years of historic precedent tells us about notable declines in M2 and the performance of the U.S. economy and stock market, a big move lower may await the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite in the not-too-distant future.
But the interesting thing about history is that investor perspective can dramatically alter the outcome.
For instance, the analysts at Crestmont Research annually update one of their data sets, which calculates the rolling 20-year total returns (including dividends paid) of the benchmark S&P 500 dating back to the start of the 20th century. Despite the S&P not existing until 1923, Crestmont was able to trace the performance of its components in other indexes between 1900 and 1923 in order to back-test returns to 1900.
Crestmont Research's data set yielded 106 rolling 20-year periods, with end dates ranging from 1919 through 2024. What stands out is that 106 out of 106 rolling 20-year periods generated a positive total return.
In other words, if an investor had, hypothetically, purchased an index fund that tracked the performance of the S&P 500 at any point since 1900 and simply held their position for 20 years, they would have made money 100% of the time. It didn't matter if they held through the Great Depression, Black Monday, the dot-com bubble, or financial crisis -- they would have made money.
The power of perspective and long-term thinking is also on display in a data set published by Bespoke Investment Group in June 2023.
Bespoke's researchers compared the length of every bull and bear market in the S&P 500 dating back to the start of the Great Depression in September 1929. This meant tabulating the calendar-day length of 27 separate bull and bear markets.
As you can see, the average downturn for the S&P 500 resolved in 286 calendar days (about 9.5 months), and no bear market endured longer than 630 calendar days. On the other hand, the typical bull market stuck around for 1,011 calendar days, with more than half of all S&P 500 bull markets (including the current bull market when extrapolated to present day) lasting longer than the lengthiest bear market.
While there's always going to be a correlative metric or forecasting tool that acts a short-term downside precursor for the Dow Jones, S&P 500, and Nasdaq Composite, the data is quite clear that patience and perspective win out time and time again on Wall Street.
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Bank of America is an advertising partner of Motley Fool Money. 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.
