Blog - Investing Notes

December 20, 2006 - Money Supply (M2) and the Stock Market

Some investing experts cite changes in money supply as an important indicator of future stock market behavior. When the money supply grows (shrinks), they theorize, asset prices go up (down). Or wait, when money supply grows, retail investors have moved to cash, and asset prices should be depressed. What do the empirical data tell us? One measure of money supply is M2, which consists of currency, checking accounts, saving accounts, small certificates of deposit and retail money market mutual funds. Is there a relationship between M2 money supply and stock market behavior? Using non-seasonally adjusted weekly M2 data and corresponding weekly S&P 500 index data for 1/5/81-12/4/06, we find that:

The following chart depicts M2 and the S&P 500 index since the beginning of 1981. The correlation between these two series is a strong 0.89, probably because both tend to rise as the economy expands. Visual inspection indicates no finer systematic relationship between them. To discover any such relationship, we need to explore relatively short-term (say, quarterly) changes in both.

Based on a sample taken at 12-week intervals (to ensure independence of data), the following scatter plot depicts the relationship between changes in M2 and changes in the S&P 500 index over concurrent 12-week periods. Sample size is 112. The Pearson correlation between the two series is a weak –0.12. When we omit the outlier at the extreme right, the correlation changes to 0.01, indicating no relationship. M2 and the stock market do no appear to move together over the intermediate term. However, a different perspective might disclose relationships for ranges of the quarterly change in M2.

The next chart offers a different perspective on the relationship between 12-week returns for the S&P 500 index and concurrent changes in M2. It orders the latter series from lowest to highest values over the entire sample period. The horizontal axis is therefore not time-sequential. We set the scales on the vertical axes to make the graphs overlap for ease in seeing how much they do or do not vary together. This format facilitates understanding whether the relationship is stronger or noisier for some levels of M2 changes than for others.

The chart generally confirms the non-relationship shown in the above scatter plot. The lack of trend in stock returns shows that they are insensitive to concurrent changes in M2 money supply. The degree to which the stock return graph bounces up and down indicates the noisiness of the relationship (as does the dispersion in a scatter plot).

Might there be a lag in the impact of money supply on stocks? Based on a sample taken at 12-week intervals (again, to ensure data independence), the following scatter plot depicts the relationship between changes in M2 over 12-week periods and changes in the S&P 500 index over subsequent 12-week periods. Sample size is 111. The Pearson correlation between the two series is a modest 0.20. This positive correlation is robust to omission of outliers, suggesting a slight tendency for the stock market to rise (fall) over the intermediate term after M2 has gone up (down). Again, a different perspective might disclose relationships for ranges of the change in M2.

The next chart offers a different perspective on the relationship between 12-week returns for the S&P 500 index and past quarterly changes in M2, ordering the latter series from lowest to highest values over the entire sample period. The graph for stock returns is still fairly trendless, suggesting that whatever weak predictive power the past change in M2 has for stock returns derives from extreme values of these past changes. The relationship has no practical value for stock traders.

In summary, M2 money supply is not a useful indicator for concurrent or intermediate-term future stock market returns.

See Blog Synthesis: The Economy and the Stock Market for analyses of the relationships between other economic indicators and stock returns.