In the financial markets, the bulls and bears can seldom manage to agree on anything. Take any number at all, it seems, and both the bulls and bears can easily interpret it to bolster their own particular worldview.
High stock valuations? No problem, say the bulls, as valuations should be high when interest rates are low. The bears, on the other hand, see this exact same valuation data as a dire warning of the coming second phase of a brutal Great Bear market barreling down upon us with a vengeance.
The falling dollar? Great for the American stock markets, claim the bulls, as it enables US industry to export into the world markets at far more competitive prices. The bears perceive things a bit differently though, seeing the ongoing dollar bear as an enormous negative for equities since it makes earning profits vastly more difficult for foreign investors who wish to bid up the US stock markets with their precious capital.
Amazingly enough however, there is at least one area in which the bulls and bears are able to miraculously set aside their deep fundamental differences and reach a tentative agreement. Neither side will dispute that a rocketing money supply tends to boost equity markets over the short term.
When money supplies are growing, all of the fresh money created by the Fed has to find a home somewhere. With relatively more money chasing after relatively fewer goods, services, and investments, the prices of these things inevitably rise. A deluge of new money tends to lift the general stock markets in a massive inflationary tide, at least initially.
Over the long run, however, monetary inflation slaughters the stock markets as we witnessed in the 1970s and early 1980s, when they fell to 7x earnings. After a long enough period of central bank promiscuity in monetary growth and depredation of savers, investors flee paper assets into real inflation-proof assets like gold and silver. But early on in an inflationary campaign, before the mortal threat to savers is widely perceived, stocks tend to thrive in the liquidity flood.
If a rapidly rising money supply tends to boost stocks for a short euphoric season, then what would a falling money supply portend? It probably would not be good, as relatively less money chasing after relatively more goods, services, and investments would lower the prices of everything, including stocks. We have not witnessed deflation in the States since the Great Depression though, and the Fed will probably print money until its printing presses melt rather than risk traveling down that feared and loathed path once again.
While shrinking money supplies are exceedingly rare in countries with fiat-paper currencies that they can expand continuously, it is possible to see vast reductions in the growth rates of the paper money supplies. Economists use the term disinflation to describe a deceleration in the growth rate of a money supply.
Provocatively we are now experiencing a disinflation in monetary growth in the United States. If an acceleration of inflation tends to initially lift stocks on a deluge of new money, what will a deceleration of inflation bode for the general US equity markets? Odds are that we are all, bulls and bears alike, going to find out in 2004!
Our pair of charts this week highlights the stalling US monetary growth compared with the flagship S&P 500 stock index. The first graph looks at the broad M3 monetary measure, while the second explores the much narrower MZM monetary gauge. The yellow line shows the annual year-over-year growth rate in each money supply, while the red line highlights their respective absolute growth (not annualized) over 10 weeks.
Both of these key US money supplies have witnessed a drastic slowdown in growth in the past couple of years and stock investors really need to carefully consider just what the potential impact on the equity markets from this rare development might be. With less monetary fuel to burn will stocks be able to continue their soaring rally?
Broad M3 monetary growth has slowed dramatically, falling from over 13% year-over-year in 2001 down to merely 4% today. The shorter 10-week growth measure has also decreased substantially, bleeding from 4% or so in 2001 down to nearly nothing today. The descending dotted arrows above for both monetary growth measures are precise linear mathematical trends of the data, highlighting the degree of disinflation in monetary growth in the US today.
Now there is no disputing that money supplies are pretty arcane and esoteric stuff. Unless you happen to be a practicing economist or total market junkie like me, odds are that you haven't wasted much of your life even thinking about money supplies, let alone investigating the actual data. Thus, it is very important to realize just how incredibly rare a rapidly decelerating monetary growth environment truly is.
In last summer's "Inflation or Deflation? 2" essay, the second graph shows the actual US M3 and MZM money supplies, the same measures used in todays graphs, back to 1960. The only time in this entire span that money supply growth slowed down considerably was in the early 1990s. Other than this one episode, there really isnt another time in modern history when money supply growth slowed as dramatically as it has today. You can see another zoomed in view of the early 1990s M3 growth rates in the first graph in M3 Growth and Stocks" if you wish.
Decelerating monetary growth, disinflation, is an abnormal state of events, a strange anomaly in an otherwise relentless rapid rise in money supplies in a fiat-currency regime. As such, any time that this growth rate in money stalls significantly, investors need to take note and carefully consider the potential consequences of such a rare development.
In annual terms, a 4% M3 year-over-year growth rate is unbelievably low. From January 1995 to March 2000 for example, the bubble years where US stocks rocketed higher, M3 grew at an average annual rate of 7.8%, which is highlighted above for reference. From April 2000 to the present, even including today's current very low monetary growth numbers, M3 grew at an even higher average annual rate of 8.7%, also drawn above.
Monetary growth accelerated during the brutal Great Bear bust as Greenspan and the Fed desperately tried to do everything possible to reinflate a doomed stock-market bubble to bailout overextended stock-market speculators. It peaked above 13% in late 2001 right after the sharpest stock-market plunge in the entire bear market to date. The Fed panicked right after 9/11 and pulled out all the stops to force feed excess capital into the system to stave off the threat of a massive crash.
As the annual monetary growth rate slowed significantly in 2002, the stock markets continued to plummet. The markets didn't really stabilize in late 2002 until the money supply growth rate itself stabilized and stopped falling. Interestingly, the war rally in US equities launched last spring also corresponded with another sharp increase in the YOY growth rate in M3. This relationship held well until mid 2003, when money supply growth and the stock markets suddenly decoupled.
The S&P 500 kept rocketing higher in the final quarter of 2003, but the rate of growth of the broad money supply continued to contract. This is quite a startling anomaly, since a slowing monetary growth rate restricts the injection of new capital into the financial system and makes it much more difficult for the general stock markets to rise. If I was long general equities right now, which I am certainly not, I would be very troubled to see stocks decoupling with monetary growth rates in the US.
The red 10-week growth line is showing the same strange phenomenon on a shorter scale. The short-term rate of growth in M3 is declining significantly as well. While negative growth rates over 10 weeks were relatively rare and far between a few years ago, now the 10w M3 growth rate is spending more and more time below zero.
It is provocative that this rate's mathematical linear trend, the descending dotted-red line, is due to punch under zero sometime in April or May. Whether you have a bullish or bearish bias, it is hard to imagine how a contracting broad US money supply over the short-term could be anything but negative for today's vastly overvalued and speculative-froth-laden US equity markets.
Before we move on to MZM, there is another weird development that caught my eye in the 10w M3 growth line. Generally, money supply growth spikes in Q4 of each year. The Fed ensures that retailers and consumers have lots of money available for the all-important Christmas shopping season, so there are usually big spikes in monetary growth in Q4. On the chart above you can see these red Q4 growth spikes at the end of 2001 and 2002.
Strangely, at the end of 2003 there was no typical spike in M3 growth. During the first part of Q4 of last year 10w M3 growth was actually negative, shrinking, and only during late November and December did this key growth rate struggle back into mildly positive territory. I am not sure how to interpret this data, but it is really odd and unexpected not to see a big Q4 monetary growth spike at the end of 2003. Perhaps the lion's share of Q4 2003 gift buying was done on credit alone, as US consumers struggled to use actual money to purchase their gifts.
Moving on, the narrower MZM money supply is much more relevant than the broad M3 in terms of monetary impact on investment assets like stocks. MZM is available to be deployed quickly and not tied up in long-term savings instruments like a large fraction of M3. As such, stock investors should pay even more attention to recent MZM developments.
As this second chart illustrates, the deceleration and disinflation of MZM growth has been even far more extreme than the same phenomenon in M3 above. In MZM we see the same general chart topography as we saw in M3, including the sharp slowdown in monetary growth, the recent decoupling of stock prices and monetary growth trends, and the mysterious lack of a Q4 2003 retailing growth spike. Only in MZM terms, all of these events are underway on a much larger and more volatile scale.
Narrower MZM money is far more volatile than the broader M3 money supply. Even when this increased volatility is considered though, the slowdown in MZM is nothing less than breathtaking. Annual MZM growth peaked near a mind-blowing 22% after 9/11, banana-republic inflation levels, and has now plummeted to only 3% or so, an extraordinary rate of decline in only a couple of years.
The descending yellow dotted line highlights the steep downward slide in MZM growth's mathematical linear trend. To gain a point of reference from which to understand just how anemic 3% annual MZM growth really is, we drew in two yellow reference lines above. From January 1995 to March 2000 during the bubble years, annual MZM growth averaged 7.5%. During the following bust from April 2000 to today, annual MZM growth averaged 11.0%.
So today's MZM growth rate has plunged to less than half of the "normal" MZM growth rate that fed the bubble years of the late 1990s and just over a quarter of the soaring MZM growth rate that the Fed used to try and retard the bust years. We are really entering uncharted territory in MZM disinflation here, as we have not yet seen the effects of such lethargic MZM growth on a hyper-overvalued stock market right after a Great Bubble burst and bust. Interesting times!
The 10w MZM growth rate is decelerating dramatically as well, having fallen from 6% in 2001 all the way down to -1% today. Yes, MZM is actually shrinking now on a 10-week scale, not merely disinflating but actually deflating! A deflating MZM money supply over the short-term ought to terrify stock investors, as the more the pool of available hot money for investment contracts the greater the headwinds the US markets will face in clawing higher.
The 10w MZM growth rate's mathematical linear trend has just crossed into negative territory as well, suggesting that shrinking MZM on a 10-week scale is here to stay unless something dramatic happens to money supply growth in the US. Shrinking monetary environments are certainly not conducive to farther fantastic gains in the American equity markets!
The massive decoupling between the rate of monetary growth and the short-term trend in the US stock markets at the end of 2003 is even more apparent in MZM terms. The final upsurge in the blue S&P 500 and the final plunge in the yellow MZM year-over-year growth rate look like mirror-image opposites on the right side of this chart. I would be really surprised if such an enormous divergence of monetary growth rates and stock gains can persist for much longer.
Armed with some fresh data and perspective, we can return to our original question. Bulls and bears both agree that monetary growth, particularly accelerating rates of monetary inflation, generally yields a short-term boost to the equity markets as relatively more money chases after relatively fewer goods, services, and investments.
But if accelerating inflation is good for stocks over the short-term, shouldn't decelerating inflation or even deflation be bad for stocks over the short-term? After all, if the pool of money available to chase goods, services, and investments is growing much more slowly or even shrinking, shouldn't stock prices have to fall to reflect the reduction in capital bidding on them?
While I can't help but have a bearish bias on the US equity markets myself since they are still trading near historic bubble valuations in trailing PE terms, I cannot see how even the most incorrigible perma-bull can interpret these troubling monetary disinflationary developments in anything but a negative light.
A rapidly rising stock market that is already greatly overvalued can only go higher if ever increasing amounts of capital bid on and chase stocks higher. A speculative mania mentality possesses investors and speculators and they cease to worry about buying stocks low, but instead they just merrily buy at any price and hope to sell to a greater fool later.
When this mania mentality arrives, the stock markets become more of a Ponzi scheme than an arena for buying truly undervalued companies in valuation terms and riding them to long-term investment profits like Warren Buffett would. In a Ponzi scheme, the folks fortunate enough to get in early make lots of money, but as soon as the scheme grows large enough so that the rate of new capital introduced into it tapers off, the whole scheme implodes.
We could certainly witness a similar reckoning in the US equity markets. If the slowing growth rates in money supplies lead to an environment where there is simply less fresh capital flooding into the equity markets, stock prices will no longer spiral higher on an increasing tide of new bids. As demand for stocks peaks and then falls, stock prices will have no choice but to correct, possibly quite aggressively. A reduction in the rate of money pouring in could flash the Game Over signal in equity-land, the point at which farther gains rapidly become impossible.
On a side note, this stalling monetary growth inevitably spawns discussions on the Fed. Since the Fed is responsible for growing the US money supplies, many people including me wonder if the Fed has purposely engineered this monetary disinflation or if forces beyond its control are dragging money-supply growth rates ever lower contrary to its will.
If the Fed is doing this on purpose, I can't understand what its motivation would be. Ever since the bubble burst in 2000, the Fed has done nothing but try to bailout overextended stock-market speculators who foolishly trapped themselves in the bubble and crash. If the Fed is suddenly tightening money supply growth, it has to know that it has a high probability of killing the nearly year-long rally in US equities by turning off the inflationary liquidity spigot.
On the other hand, if the Fed is losing control of the money supply, what could be causing the rapid reduction in US monetary growth rates? If interest rates were rising already, we could probably assume that debt defaults were accelerating, as declining debt levels have a multiplied effect on money and credit levels in an economy dominated by fiat currency and fractional-reserve banking. But with interest rates holding at brutal 45-year lows, debt defaults have probably not yet been pummeling monetary growth rates since 2001.
Another fractional-reserve banking possibility is that the debt market is saturated. With consumers and corporations deep in debt up to their ears after the Fed encouraged them via unnaturally suppressed short-term interest rates, perhaps there is little interest or capacity for more borrowing. Additional borrowing increases money supplies through the fractional-reserve multiplier effect, so lower borrowing could reduce monetary growth rates.
So while I really doubt that the Fed would intentionally eviscerate its monetary inflation rates in such a fragile post-bubble environment, I haven't yet reached a firm conclusion on exactly why the Fed could be losing control of monetary growth rates either. I hope that the causes behind these surreal monetary events will become clearer as 2004 rolls on, but for now they remain rather mysterious.
Can a powerful rally in US equities continue marching northward even in the face of stalling monetary growth rates? Â Can stocks soar even higher while disinflationary forces dry up the deluge of liquidity that they so desperately need for fuel?
Only time will tell, but if I was long the hyper-overvalued US markets like the bulls are here, I would sure be nervous after looking at these stalling monetary growth charts!