Money Supply (M2) and the Stock Market

http://www.cxoadvisory.com/economic-indicators/money-supply-m2-and-the-stock-market/

Money Supply (M2) and the Stock Market
Posted in Economic Indicators
July 5, 2010Share Post



Some investing experts track change in money supply as a potentially important indicator of future stock market behavior. When the money supply grows (shrinks), they theorize, asset prices go up (down). Or, money supply growth drives inflation, thereby elevating discount rates and depressing equity valuations. One measure of money supply is the M2 money stock, which consists of currency, checking accounts, saving accounts, small certificates of deposit and retail money market mutual funds. Is there a reliable relationship between historical variation in M2 and stock market returns? Using weekly data for seasonally adjusted M2 and the S&P 500 Index during November 1980 through June 2010 (1,546 weeks), we find that:

The following chart depicts M2 and the S&P 500 index over the entire sample period. Both series have generally risen as the economy grows (and inflates), but the stock market is far more volatile than M2. Visual inspection is not helpful in discovering any relationship between the two series.

To dig deeper, we relate changes in the two series.



The following scatter plot relates weekly change in M2 to same-week change in the S&P 500 Index over the entire sample period. One of the observations in September 2001 is a two-week relationship because U.S. stock markets were closed. The Pearson correlation between the two series is 0.01, and the R-squared statistic is 0.00, indicating that weekly variations in M2 explain nothing about concurrent weekly stock market movements.

Might the effect of money supply be evident only over longer intervals?

Relating the 4-week change in M2 and same-interval change in the S&P 500 Index (sample size 387 non-overlapping intervals), the Pearson correlation is -0.09 and the R-squared statistic 0.01.

Relating the 13-week change in M2 and same-interval change in the S&P 500 Index (sample size 122 non-overlapping intervals), the Pearson correlation is -0.14 and the R-squared statistic 0.02.

Relating the annual change in M2 (selecting the M2 reports nearest to year-ends) and same-year change in the S&P 500 Index (sample size 30 years), the Pearson correlation is -0.16 and the R-squared statistic 0.03.

It appears that strength of relationship may grow as measurement interval increases, but sample size decreases as measurement interval increases. The relationship becomes more negative, suggesting a fear of inflation/elevated discount rate effect. None of the relationships indicate a compelling material (tradable) relationship between changes in M2 and U.S. stock market returns.



A reader suggested looking at the relationship between real change in M2 (inflation-adjusted by subtracting the contemporaneous 12-month inflation rate derived from the all-items Consumer Price Index) versus stock market returns. The next scatter plot relates annual changes in M2, both nominal and real, to same-year change in the S&P 500 Index over the entire sample period. The relationship between real change in M2 and stock returns is weaker than that between nominal change in M2 and stock returns. A shared dependence of the two variables on the inflation rate or small sample size may explain the difference.

Might there be a non-linear but reliable effect of M2 variations on stock returns?



The next chart summarizes average S&P 500 Index returns across quintiles of ranked changes in M2 over intervals of one, four and 13 weeks over the entire sample period. At the longer measurement intervals, there may be some tendency for stronger returns when M2 growth is lowest (again suggesting the effect of change in M2 on discount rate). However, the progressions across ranges of M2 growth are not completely systematic, and there are only 24-25 observations per quintile for the 13-week interval.

Might changes in M2 lead changes in stock market returns?



The final three charts explore potential M2-stock market lead-lag relationships for non-overlapping intervals of one, four and 13 weeks over the entire sample period by offsetting changes in M2 relative to changes in the S&P 500 Index. Specifically,

The top chart relates the weekly change in M2 to the weekly change in the S&P 500 Index for offsets ranging from the stock market leads M2 by 13 weeks (-13) to M2 leads the stock market by 13 weeks (13).

The middle chart relates the 4-week change in M2 to the 4-week change in the S&P 500 Index for offsets ranging from the stock market leads M2 by about six months (-6) to M2 leads the stock market by about six months (6).

The bottom chart relates the 13-week change in M2 to the 13-week change in the S&P 500 Index for offsets ranging from the stock market leads M2 by about four quarters (-4) to M2 leads the stock market by about four quarters (4).

Correlations are generally small, and the lead-lag variations appear to be mostly noise. The third chart suggests the stock market may anticipate long-term increases in M2 (by declining), but the level of any such anticipation is economically weak.

In summary, evidence from simple tests does not support a belief that M2 money stock is a useful indicator for short-term or intermediate-term future stock market behavior.