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Why money matters for US equities

The US money stock tells us that shares might be expensive.
May 7, 2021

Are US equities being driven up simply by a massive expansion in the money stock? It certainly looks as if they are. The M2 measure of the money stock (which comprises most bank deposits and retail money market funds) has recently been growing at its fastest rate on record, rising by over 24 per cent in the year to March. Is it really a coincidence therefore that the S&P 500 has risen over 40 per cent in the last 12 months?

Well, yes it is. If there were a link between monetary growth and equity returns we’d have seen it before now. And we haven’t. Since 1970 there has been zero correlation between annual growth in M2 and annual changes in US equity prices – which is true even allowing for a lag of up to two years between monetary growth and equity returns. For example, strong rises in the money stock in 2001 and 2008 were accompanied by falls in share prices, and many rises in the market have come without any significant upturn in monetary growth, such as in the late 1980s, mid 1990s or in 2013.

Equity returns have been much more volatile than monetary growth – four times as much so since 1970. This tells us that many things drive returns other than the money stock.

There’s a simple reason for this lack of correlation. Variations in money growth are usually determined by changes in people’s desire to hold money. It’s usually not the case that people find themselves holding too much cash which they use to buy equities.

Why then have the money stock and share prices both shot up in the last 12 months? It’s a pandemic effect. In shutting shops and restaurants the pandemic forced people to save more. Between 2013 and 2019 Americans saved between 6 and 8 per cent of their income. At the peak of the pandemic this fraction rose to over one-third, and even at its low-point last year it was still over 13 per cent. Many of these savings were in cash – hence the boom in M2. And as hopes of an end to the pandemic have grown, so shares have bounced back. All this is a classic example of correlation without causality.

Nevertheless, there could be some causality soon. Not everybody will spend their pent-up savings and their stimulus cheques on guitars (the fools). Some might well shift their cash into equities instead: anecdotal evidence says some are already doing so. Even though most of the rise in equities so far isn’t the result of growth in they money stock, some of it might soon be.

We know that equities are prone to momentum. The mere fact that they’ve risen so much – for whatever reason – is therefore itself a reason to suspect they could rise further.

There is, however, a big obstacle to such a rally lasting for long. It lies in the ratio of M2 to share prices. Thanks to years of prices rising faster than the money stock, this is now closest to its lowest level since 2007. Which tells us something important. It tells us that Americans already own lots of equities and little cash. With equities being such a big part of their portfolios, there’s a limit to how much further they can shift into them – especially as Treasury Secretary Janet Yellen has told them that returns on cash might well improve soon.

History tells us that this ratio matters. When it has been low in the past, such as in 2000 and 2007 shares have subsequently fallen. And when it has been high, as in 2003 or 2009 they have subsequently risen.

Now, this predictability overstates the significance of the money stock. What it is telling us instead is that equities sometimes over-react, rising too far (as in 2000 or 2007) or falling too far (as in 2003 and 2009) and therefore eventually reversing those moves. Given this tendency, the ratio of share prices to any stable thing would predict returns.

No matter. The fact is that the money stock does tell us something – that shares are now relatively expensive and so there is a heightened risk of them falling. If the post-2000 relationship between the money-price ratio and subsequent three-year changes in shares continues to hold, then equities will rise less than ten per cent between now and 2024, with a greater than one-in-three chance of them being lower then than they are now.

Bears of the US market might well be wrong to say this is a money-fuelled rise in prices. But they are right to be cautious.