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Economy follows Money Supply 2303283

The M3 is my favorite gauge of tracking Money Supply, because it’s all encompassing; however, reported official M3 data is several months old, so the below chart uses the recently updated M2.

The economy (as well as the Stock Market) rises and falls with the amount of Money Supply, much like the flow of a river downstream from a dam.  The amount of water released from a dam (liquidity) has a direct impact on the flow of the river.  Water is regulated at the dam for flood control; Money Supply is regulated to control the business cycle.  [ Don’t shoot the messenger. ]

We’re currently in the contraction phase of the business cycle.  (See article dated 3/17/2023: Understanding the Business Cycle.)  The likelihood of a recession, the decline in corporate profits and the corresponding bad economic news (recent bank failures) is to be expected.  It’s exactly what the monetary Central Planners want to happen.

To further illustrate the point, the below chart shows how the Pandemic era expansion of the money supply has “flooded” the economy.  I’ve penciled in a rudimentary extrapolation showing how drastically the supply of money is above the pre-Pandemic trend line.  There’s roughly 22% more money in the system.   (This back-of-the-envelope calculation tracks well with official inflation numbers.)  That means even with recent restrictive Fed policies, there’s still about 4.5 years’ worth of money sloshing around in the system.  The metaphoric economic river is still at a flood stage.  Thus, the S&P 500 is hovering around its 200dma and MEME stocks haven’t gone bankrupt…yet. 

So my best guess is that the Fed keeps monetary policy tight to broadly restrain the economy, but uses targeted injections of liquidity to support “systemically important” institutions.  (Think Banks, Pension Funds, Insurance Companies & Defense Contractors, to name a few.  Check with your Senators, they probably have a specific list.)

From the chart, note that peak liquidity occurred in January 2022.  Since then, the S&P 500 is down approximately 17%.  It’s almost a guarantee that as long as liquidity continues to come out of the system, the Stock Market will go lower.

Over the coming weeks, 2023Q1 earnings will be released, along with forward estimates which will likely be revised lower.  Depending on the severity of bad news, valuation compression could drop the S&P 500 to the 3300-3000 level.  (The pre-Pandemic high was 3300; the pre-Trump Trade War high was 3000.  Think of the Barbra Streisand song- The Way We Were.) 

If there’s a Black Swan event, it could go much lower.  Perhaps 2600?  (The Pandemic low was 2300, which I don’t think will be tested, short of something like tactical nukes being used in Ukraine, because baseline fundaments have been so distorted by systemic inflation.

It’s important to remain nimble.  We don’t know how long the Fed will be restrictive, their actions are schizophrenic at best.  I’m cynically preparing for the next opportunity.  Stay tuned. 

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