On a grand scale, you could argue that the level of the stock market is set by two forces: the supply of ‘paper’, which comes from initial public offerings (IPOs), secondaries and other corporate actions, and on the other side, the demand of stocks which is not only influenced by the sentiment of investors but also by valuation and perhaps most importantly, by the supply of money in the economy.
The amount of money sloshing around the economy matters because eventually it has to find a home. In the past decade we’ve seen it rush into two markets, causing sequential bubbles in tech stocks and real estate.
One way to look at the relationship is to chart the change in change of money supply and see how it corresponds to the market and the economy. The chart below shows 35+ years of monthly data but before you can make sense of it, some explanation is needed:
Data: St. Louis Fed (FRED database)
M2 is a widely used measure of the money supply but since inflationary and deflationary periods can warp it, we look at inflation adjusted M2 (using CPI numbers). This gives us ‘real’ M2 which is more useful to compare across time. But we also have to account for the number of people in the economy because everything else being equal, on average, the more people we have the more money is used by them. So we divide the real M2 by the estimated monthly US population to get per capita, ‘real’ M2.
Then finally, we are interested in the annual rate of change that occurs in the real per capita M2 money supply, which gives us the chart you see.
The middle line represents zero, so anything above that means that the rate of change in money supply is positive and the Fed is pumping money into the economy (and vice versa). Obviously, the more extreme the move and the more the line stays above the 7 year moving average, the more significant it is.
From the latest data available (January 2009), the annual rate of change is higher than it has ever been - even higher than the early 1980’s. This means that eventually, as it works its way through the economy, there will be more and more money chasing fewer shares, driving up the level of the stock market.
Credit for this measure comes from an article by Norman P. Poiré, published in Barron’s on August 28th, 2000. If you aren’t a subscriber, you can read the article on Poiré’s website.
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