Money Supply (M2) and the Stock Market

Some investing experts cite change in money supply as a potentially important indicator of future stock market behavior. When the money supply grows (shrinks), they theorize, nominal 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 October 2011 (1,619 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 13-week S&P 500 Index return to same-interval change in M2 over the entire sample period. The Pearson correlation between the two series is -0.12, and the R-squared statistic is 0.01, indicating that quarterly variation in M2 explains 1% of the variation in concurrent stock market movements.

This conclusion is not very stable. Removing the single observation to the lower right changes R-squared to 0.00.

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

The following table presents Pearson correlations for four measurement intervals and both concurrent and next-interval S&P 500 Index returns (M2 Leading) over the entire sample period. Correlations are generally small (especially for M2 Leading) and negative. If anything, there is slight indication than a rise in M2 is bad for stocks (suggesting a fear of inflation/elevated discount rate effect).

For the concurrent relationship, it appears that strength of relationship grows as measurement interval increases, but sample size decreases as measurement interval increases.

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 Consumer Price Index) versus stock market returns. The next scatter plot relates annual change in M2, both nominal and real, to same-year S&P 500 Index return over the available sample period. While both relationships are negative, the real change in M2 and stock market returns is weaker than that between nominal change in M2 and stock market returns. A shared dependence of the two variables on the inflation rate or small sample size may explain the difference.

Might there be a useful non-linear effect of M2 variations on the stock market?

The next chart summarizes average concurrent S&P 500 Index returns across quintiles of ranked changes in M2 over measurement intervals of one, four and 13 weeks for 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 systematic, and there are only 25 observations per quintile for the 13-week interval.

Might changes in M2 convincingly lead stock market returns at some longer horizon?

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 S&P 500 Index returns. Specifically,

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

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

Correlations are generally small, and the lead-lag variations appear to be mostly noise. However, most readings indicate a negative relationship.

Given the several-week delay in availability of M2 data, it appears very unlikely that M2 changes are useful trading signals.

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

Cautions regarding findings include:

• Sample size is not large for the longer measurement intervals, especially for the quintile breakdown.
• Effects of M2 changes on the stock market may derive from level of surprise rather than level of change. However, determining level of surprise is problematic.

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