Barron's: The Money Effect
Barron's Features
August 28, 2000
The Money Effect
Maybe Greenspan & Co. should focus on this
By NORMAN P. POIRE
Over the past five years, Fed Chairman Alan Greenspan repeatedly has fretted over the "wealth effect,"
the controversial theory that rising stock prices encourage investors to spend more money.
Greenspan and many other economists fear that greater spending could lead to higher inflation -- high
enough
to perhaps force the central bank to rein in the greatest economic expansion on record by raising interest
rates.
If prudence dictates at least a modest attentiveness to the issues surrounding the wealth effect,
then it demands diligent consideration of what I call the "money effect."
This asserts that greater stores of money (from rising economic growth) lead to higher stock prices.
Before seriously investing in stocks, a person must have more funds than are needed to meet expenses.
Often, this excess accumulates first in a checking account. Once the sum is large enough,
it might be moved to a bank savings account, where it can earn interest.
Finally, as savings swell, all or part of them move into the equity market through a brokerage account.
An individual's purchase or sale of stocks will have very little impact on share prices.
A large number of people buying or selling at the same time, however, can move quotes dramatically.
When viewed in the aggregate, an implicit relationship exists between the amount of money in the
economy
and the sum that finds its way into the equity market: As the money supply increases,
shares trend upward, and when the money supply slips, stocks trend lower.
The measure of money supply used in my analysis is M2, as defined by the Federal Reserve
Board.
Included in it are currency, bank checking accounts, bank savings accounts,
time deposits (certificates of deposit, for example) under $100,000 and some other financial
instruments.
Because inflation in the latter half of the 20th century eroded the value of the dollar substantially,
nominal M2 when viewed over a long period must be adjusted for its reduced purchasing power.
So I've adjusted nominal M2 by the rate of inflation as measured by the consumer price index.
This produces what I term the real M2 money supply. Additionally, the more people there are in an
economy,
the more money is needed to produce any specific effect.
So, to generate a reading for real per capita M2, I've divided the inflation-adjusted M2 money supply
by the total U.S. population. And because real per capita M2 is a mouthful, I've shortened it to RPCM2.
interactive.wsj.com
The chart shows the annual change in RPCM2 over the past 30 years (expressed in year 2000
dollars).
When the line resides below zero, the amount of RPCM2 is less than it was the prior year,
and when the line is above zero, RPCM2 is greater than it was a year before.
Over the 30 years, RPCM2 grew at an average annual rate of about 2%.
This means the line spent more time above zero than below it.
For that reason, a seven-year moving average line is also plotted on the chart.
When RPCM2 stays beneath the moving average for an extended period, I label that stretch a Bust.
When it is above the average, I call the period a Boom.
In the two Booms, stocks as measured by the S&P 500 Index averaged annual gains exceeding 15%
(with dividends excluded and after subtracting inflation). In the two Bust periods, stocks depreciated by
more than 1%
(again, using the same adjustments).
The lesson: Money-supply growth and stock-market gains move hand-in-hand.
This conclusion has important implications for the current year.
With the June 2000 data now in, the RPCM2 line has crossed below its seven-year moving average
for the first time since 1987. This clearly doesn't paint a promising picture.
It would appear, based on past evidence, that the days when investors could count on
making easy money on Wall Street are gone, at least for now.
And there's more unpleasant news.
In the past three decades, there have been three times when
RPCM2 fell rapidly from lofty levels down through its
moving average.
These stretches are labeled A, B and C on the chart.
The worst bear market since the Great Depression accompanied
money slide A in 1973-74.
During that decline, the S&P 500 Composite index lost over 47% of its value from
start to finish.
In money slide B, the market continued to rise until two
months after RPCM2 crossed below its moving average.
Two additional months later, the crash of 1987 helped
erased nearly 35% of the S&P 500's value.
Taken together, these two market declines represent the
worst bear markets over the 30 years.
In both cases, stocks kept slumping until the slides in
the money supply reversed.
The most recent drop in the money supply, designated by C,
has thus far been accompanied by a 30%-plus decline in the
Nasdaq Composite index.
On the other hand, the large-cap stock indexes, such as
the S&P and the Dow Industrials, have suffered relatively
little.
It's certainly possible that the bear market of 2000 is already behind us.
But in the two previous money slides, the damage didn't end
until real per capita M2 broke above its moving average.
Thus, real trouble could be lurking just ahead.
NORMAN P. POIRE is a market analyst, author, lecturer and
president of Market Innovations (market-innovations.com1),
an online investment advisory firm.
URL for this Article:
interactive.wsj.com.
Hyperlinks in this Article:
(1) market-innovations.com |
