M3 Growth and Stocks
Adam Hamilton November 7, 2003 3161 Words
In the esoteric world of money supplies, it is not very often that something truly unusual transpires. Endless fiat-currency expansion, inflation, is as predictable as the four seasons as long as mere mortal central bankers wield their unfathomable power over global economies via active paper-currency manipulation.
In recent months however, the almost unthinkable is unfolding before our very eyes. The broad US money supply, M3, has started modestly contracting over the short-term! Contracting! After slamming into an all-time-high apex of $8,925b in early August, M3 had contracted by $135b as of the latest weekly Federal Reserve reporting of late October.
During the 10 weeks since M3 peaked, it has registered weekly 10-week contractions in an amazing 6 of these recent weeks! Nothing like this has been witnessed since early 1994, almost a decade ago. In a chaotic modern financial world where central bankers swear by the motto “inflate or die”, this provocative monetary development is certainly worthy of contemplation.
Is M3 really shrinking!?! Has this monetary bane of the central bankers’ existences happened before? How have past slowdowns in M3 growth affected the stock markets? And what are the implications going forward this time around? This week I would like to examine the recent past in the hopes of illuminating some useful insights on these very important questions for contrarian investors.
Since weekly M3 topped out in early August, I have seen increasing coverage of this fascinating development in the contrarian investing community, and rightly so. Many of the commentaries that I have read aggressively highlight the contraction of M3 money in recent months. But is M3 really shrinking? The true answer is yes and no. How’s that for a paradox?
Like so many studies of the markets, the actual answer really depends on the length of time considered. Perspective, as usual, is everything! If you use a short-term measure of monetary growth, like a few months or less, the M3 money supply truly is contracting over the short-term, amazingly enough.
And this certainly is an ominous development in today’s hyper-leveraged debt-worshipping financial world! Ever-increasing debt and speculative leverage can only be maintained via ever-increasing monetary inflation. Monetary disinflation or even deflation ultimately forces incredibly painful debt liquidation, eviscerating leveraged speculators.
But, from a more strategic perspective of an entire year, the US M3 money supply is still rocketing ahead from where it was last autumn. Year-over-year monetary inflation or growth is running full steam ahead on all cylinders, as mega-inflationist Alan Greenspan continues to zealously compete with 18th Century France’s John Law for the dubious crown of being remembered as the most notorious debaser of currency in all of world history.
With short-term M3 growth stalling but long-term M3 growth remaining relatively aggressive, I believe it is quite a stretch to declare that the monetary sky is falling after only a few months or so of contracting data. Yet, the recent weakness in M3 inflation still certainly could be the start of a far larger and more ominous trend so it must be carefully monitored in the months ahead.
Our trio of graphs this week offers many insights into this recent monetary anomaly and what it could portend for the US equity markets. The weekly flagship S&P 500 data, along with its primary 10-week and 40-week moving averages, is superimposed over the top of both the short-term 10-week (red) and long-term year-over-year (yellow) M3 money supply growth.
We will start with the grand strategic picture since 1990, then zoom into the euphoric bubble-top years, and finally conclude with the recent brutal Great Bear years. Using a broad initial perspective as our point of embarkation helps ensure that we resist the considerable temptation to pull the recent monetary contractions out of their proper long-term context. History, rather than emotion, needs to be our guide.
This big picture helps illustrate the conflicting signals at play in M3 today. The lower red line, the 10-week growth of M3, is what is catching the attention of countless contrarian investors today. Over the latest 3 weeks of Fed data, this 10w growth measure has fallen by -1.31%, -1.31%, and -1.27%. To place this kind of magnitude of short-term monetary contraction into proper perspective, -1.31% is the largest 10-week absolute drop in M3 since at least 1989, which is as far back as we ran these numbers for this essay.
Way back in February 1993 this 10w growth measure of M3 sunk to -1.28% for one week, and exactly one year later in February 1994 it fell to -1.27% and -1.26% for two consecutive weeks before recovering and surging. Other than these two early 1990s episodes though, we have not witnessed anything else close to the recent -1.31% back-to-back 10w drops in M3 in modern financial history.
The current steep plunge in the red 10w M3 growth line above is definitely an anomaly and worthy of note, even when well over a decade of financial-market and monetary history is considered. It has been an entire decade since anything remotely close to this sharp drop in short-term M3 growth has been witnessed, so we will have to watch M3 closely in the months ahead to see if its short-term growth rate plunges even lower into record negative territory.
Now as an incorrigible contrarian and outspoken bear these days, I would love to draw the conclusion that this plunging short-term M3 growth heralds the long overdue next downleg of the Great Bear. Yet, when I ponder the yellow longer-term year-over-year M3 growth line above, a true strategic M3 contraction is nowhere in sight at this point. The entire US money supply is 6% larger today than it was a year ago, even after the short-term M3 contraction!
Currently M3 is running about $8,790b according to the Fed. This is 6% higher than the $8,285b M3 of late October 2002, 13% higher than M3 was in October 2001, 26% higher than M3 in October 2000, and a neck-snapping 39% higher than M3 in October 1999! 6% year-over-year broad monetary inflation is certainly not an M3 contraction by any stretch of the imagination! So while the short-term trend is very provocative, it is too young at this point to trump the long-term reality of gigantic monetary inflation.
Before we delve deeper and zoom into the bubble years and then the Great Bear years below, there are a couple interesting points to note regarding this long-term strategic chart shown above.
First, if you examine the yellow year-over-year M3 growth line, it is impossible to miss the painfully obvious fact that the Great Bull market of the past couple decades really didn’t begin its ultimate terminal blowoff phase until M3 growth began skyrocketing in 1995.
In the early 1990s prior to 1995, annual M3 growth averaged a modest and remarkably constrained 1.46%. I have to chuckle at this quaint number because in our surreal post-bubble years today where the Fed frantically tries to micro-manage the entire global financial system, surely similar 1.5% annual M3 growth today would be considered The End of The World, Financial Armageddon, by Wall Street. How times change!
Yet, the major bull-trend in fair-valued US equities in the early 1990s had no problem at all marching relentlessly forward without the Fed inflating away the US dollar into nothingness like it foolishly chose to do during the late 1990s. Currency debasement is not necessary for valuation-justified bull markets!
Second, the entire massive bubble top above, encompassing the late 1990s and early 2000s, corresponded with utterly outrageous monetary growth. Annual M3 inflation today, at 6%, is right on the verge of falling to its lowest point ever in the entire bubble and bust. What would happen to the US equity markets today, not to mention residential real estate, if the Fed’s liquidity deluge tapered off to sub-2% YoY growth rates as in the early 1990s? I suspect that it would not be pretty for leveraged speculators, both in stocks and real estate!
If annual M3 growth continues to fall back towards early 1990s levels, then we in the contrarian community will truly have something to get excited about. The recent plunge in 10w M3 growth could very well be heralding such a vast reduction in the strategic annual M3 growth rates, but only time will tell if this really proves to be the case or not.
If soaring money supplies fueled this bubble, as they have all the other major bubbles in history, a huge reduction in monetary growth will certainly slaughter the fading remnants of the bubble and usher in the rest of this Great Bear bust. Assets, regardless of if they are stocks, real estate, or whatever, can only be pushed above economic fair value related to the cashflows that they can actually spin off when great floods of inflationary monetary growth begin to chase them. Turn off this immense M3 firehose, and there will be no monetary pressure left to support hyper-inflated asset prices.
If the annual year-over-year M3 growth rate starts plunging as much as the short-term 10-week M3 growth rate has, watch out below in all the overpriced financial-asset markets. I really doubt that the major asset bubbles in the United States can survive if their fresh blood supply of inflationary new currency is vastly reduced. I am really interested in this annual M3 growth line myself and will be carefully observing it in the weeks ahead and writing update essays on it in the future.
Now that we are blessed with the benefit of the long-term strategic perspective, we can delve into the short-term with less of a risk of misinterpreting current monetary events. We know that 10w M3 growth is just under the lowest that we have witnessed since at least 1989, that annual M3 growth is pushing its lowest levels since the terminal blowoff stage of the bubble ignited in the mid-1990s, and that we truly could be on the very verge of extraordinary monetary events.
Zooming into just the bubble years highlighting the massive long-term US equity top offers us a higher resolution view of more recent M3 growth within the strategic frame of reference discussed above.
Some of the strategic monetary developments that fueled the Great Bubble in US equities late last decade are far clearer at this resolution. It boggles my mind that the country managing the world’s reserve currency could get away with inflating broad money at 11% in the late 1990s and over 13% in late 2001. This outrageous annual inflation is on the verge of approaching banana-republic regimes and it is amazing that so few folks apparently see it for the huge structural problem that it is.
I also find it provocative to observe how the effectiveness of monetary inflation injections so dramatically vaporized in the Great Bear years as compared to the preceding Great Bull years. Between 1996 and 1999, soaring M3 YoY growth helped fuel a breathtaking rally in the US stock markets, the terminal bubble blowoff stage of a massive Great Bull. Even when the Fed tried to rein in its monetary promiscuity in 1999, the rate of ascent of the S&P 500 slowed dramatically. In the Great Bull years the markets appeared to be quite responsive to monetary inflation.
Since early 2000 however, the enormous and unchallengeable Long Valuation Waves have shattered Fed monetary manipulation’s influence on the markets like a sledgehammer to the Fed’s skull. Once the Long Valuation Wave Mean Reversion and Great Bear kicked in, no amount of monetary inflation would derail this necessary post-bubble adjustment process. The Fed tried desperately, even ramping up M3 by a phenomenal 13% in late 2001, but all to no avail.
While the late 1990s acceleration of M3 growth fed the Great Bubble, the early 2000s acceleration of M3 growth didn’t even have a prayer of stopping the Great Bear. The S&P 500 and US markets plunged like stones even while the Fed frantically goosed M3. Short-term bear-market rallies seemed to correspond with M3 annual growth-rate spikes rather nicely, but they never lasted long. Even the mighty Fed, which basically controls or influences all of the fiat currency in the world indirectly, is no match for a supercycle Great Bear!
Shifting to the red 10w M3 growth line again, such sub-1% contractions as we are witnessing today are totally unprecedented within the bubble-topping years. Prior to 2003 it seemed like about once a year the M3 10w growth rate would briefly fall negative, every summer, but it was quickly and aggressively ramped back up to levels greater than 3% in every case. Yet, when the Fed tried to do this again in 2003, the best it could hit was a little above 2% before 10w M3 growth plummeted down to where it is today, assaulting official contraction territory.
Since we have not yet witnessed what this extreme rate of monetary deceleration does to vastly overvalued markets in modern United States history, we need to watch these monetary developments closely in the months ahead. With the S&P 500 trading at almost 27x earnings as I discussed in the just-published November issue of our Zeal Intelligence monthly newsletter for our clients, any significant reduction in monetary inflation could be extraordinarily damaging to the equity markets.
Overvalued markets are like a ball suspended above a water fountain. The ball has no problem at all staying aloft as long as the water pressure under it from the fountain’s jets remains sufficient to levitate it. But, if the fountain’s flow is slowed to a relative trickle, the suspended ball will tumble out of the air as gravity overcomes the weakened jets’ support. The ball can only stay floating in the air if the water pressure supporting it remains adequate.
Vastly overvalued markets, similarly, can only remain aloft when fresh money is constantly thrown at them. The ultimate fountainhead of this new currency in our modern paper world is central banks like the Fed. If the Fed cannot keep the fountain pressure high enough to support the levitating markets via enormous inflationary “liquidity injections”, basically outrageous M3 growth, then the markets will ultimately come tumbling down to fundamentally fair-valued levels just like the ball suspended above the water fountain.
Perhaps 6% annual M3 growth, near the lowest levels witnessed in about 8 years, and the unprecedented in the bubble years -1.3% 10w M3 shrinkage will indeed prove to reduce liquidity pressure low enough that the US markets will be unable to levitate near their current unnaturally high levels approaching 30x earnings any longer. Once again we will have to monitor the M3 growth rates closely in the months ahead to see how this all plays out.
Our final graph zooms in one last time, to just the Great Bear years. This allows us to analyze the apparent effects of monetary growth in a secular bear market. Provocatively the very same M3 acceleration that fueled the Great Bull market of the late 1990s has been utterly impotent and powerless to stop the insatiable Great Bear of the 2000s. Manipulation is always utterly futile over the long-term!
In annual M3 growth terms, no level of M3 inflation has been able to overcome the selling of rampantly overvalued stocks so far in our Great Bear. 9% to 11% was not sufficient in 2000 to keep the Great Bubble from imploding and entering its bust phase. Even an unthinkable 13%+ was unable to stem the bearish tide in late 2001, and shortly after this immense inflation effort failed the most brutal waterfall decline of the entire bear market to date commenced in early 2002.
If even massive broad monetary inflation running over twice as high as today’s 6% was unable to inject enough fiat liquidity into the equity markets, odds are that today’s relatively meager 6% annual growth rate will certainly prove ineffective as well. Central bankers have long tried to stave off Great Bear supercycle busts by printing money, but this inherently flawed strategy always fails in history and is certainly also doomed this time around.
The red 10w M3 growth line is really interesting from this zoomed-in perspective too. Many of the bear-market rallies and topping periods of this Great Bear so far have corresponded with or followed shortly after relatively high short-term M3 growth in the 2% to 4% absolute range over only 10 weeks. Yet, as soon as these short-term bursts of marginal M3 growth abate, the markets seemed to fall pretty hard as the liquidity that they desperately needed to levitate at unnaturally high valuations began to dry up. Without those fountain jets of fiat-currency inflation, fundamental gravity rapidly takes over and drags the markets lower.
The only time that this pattern didn’t play out this way was during the odd war rally of 2003. In July the S&P 500 and US markets appeared to be topping, and indeed both longer-term and short-term M3 growth began to decelerate. Yet, rather than roll over right away the stock markets managed to drift higher.
I call it a drift because the move since August lacked conviction. It was a low-volume low-volatility move higher, made possible more by a lack of sellers than anything else. There were no big buyers, no high volume, no huge capital inflows, but even small buying can nudge markets higher when sellers are not willing to sell for one reason or another. As I discussed a couple weeks ago in “SPX Volatility Extinctions” even the low volatility itself is another telltale warning sign of a major interim top.
While short-term M3 growth is certainly at its lowest level in this entire Great Bear, longer-term annual M3 growth is rapidly approaching bear-to-date lows as well. While we really need to accumulate more future data to see if these decelerating monetary inflation trends continue, it cannot be good for the stock markets if they do. Overvalued markets need tremendous inflationary liquidity injections to levitate, and without fresh fiat currency fundamental gravity wins out and they ultimately plunge.
From a contrarian-investor perspective, I believe that the current M3 growth picture suggests that extreme caution is in order. Short-term M3 shrinkage is indeed happening and certainly will not help the stock markets, but annual M3 growth still remains fairly high historically at 6%. If either of these M3 growth rates continues to fall in the months ahead however, it will probably be very bad news for the chronically overvalued US equity markets. We may indeed soon find out exactly what level of fiat inflation is necessary to levitate stocks around 30x earnings in a Great Bear!
In the meantime though, until we see these early M3 deceleration trends develop farther, it is probably best to prudently watch and wait. The Fed is not going to let the lifeblood fiat inflation of the stock markets contract without an epic fight, even if it is going up against titanic Long Valuation Wave forces that it cannot possibly overcome.
The coming M3 inflation developments in the months ahead ought to be quite interesting.
Adam Hamilton, CPA November 7, 2003 Subscribe at www.zealllc.com/subscribe.htm