Note: The following article was reprinted in edited form in BARRON'S
business and financial weekly magazine in the August 28, 2000 issue.

Copyright © 2000 by Norman P. Poire. All rights reserved.

By Norman P. Poiré

On various occasions over the past five years, Fed chairman Alan Greenspan has expressed his disquietude over the so-called wealth effect. At the heart of this controversial phenomenon is a seemingly common sense but unanswered question: do shareholders react to rising stock prices by spending more money? Greenspan and many economists are occupied by this query because they fear that greater spending could lead to higher inflation rates -- high enough to perhaps reign in the greatest economic expansion on record.

As investors, we also need to be alert to any potential fallout of the wealth effect. A rising general price level has rarely been an ally to equity appreciation. Furthermore, tactical strikes by the Fed to check inflation’s advance can be equally devastating to stocks, at least in the short run. Just witness the carnage in the NASDAQ Composite index following the latest round of interest rate increases.

If prudence dictates at least a modest attentiveness to the issues surrounding the wealth effect, then it demands a diligent consideration of a related phenomenon I have dubbed the money effect. The money effect is what one might expect to get after shuffling the variables in the wealth effect deck. Specifically, the wealth effect hypothesizes that greater wealth (from rising stock values) leads to higher spending and economic growth while the money effect asserts that greater stores of money (from rising economic growth) lead to higher stock prices.

We can appreciate how the money effect works by viewing it on an individual level. A person must have an excess of funds over and above his or her expenses before seriously contemplating an investment in equities. Normally this excess money will accumulate first in a personal 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 increase, all or part of the savings can be moved into the equity markets 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 prices considerably. When viewed in the aggregate, an implicit relationship exists between the amount of money in the economy and the amount that finds its way into the stock market: as money supply increases share prices trend upward and when money supply is declining share prices trend lower.

Before presenting the empirical evidence, I will first define what is meant by money. The measure of money supply used in my analysis is M2 as defined by the Federal Reserve Board. Included in this classification are currency, bank checking accounts, bank savings accounts, time deposits [CD's, for example] under $100,000, money market accounts, and a couple of other arcane financial instruments.

Because inflation in the latter half of the 20^th century has eroded the value of money substantially, nominal M2 when viewed over a long time period must be adjusted for its reduced purchasing power. So I have divided nominal M2 by the rate of inflation as measured by the consumer price index (CPI). This leaves us with a measure we call real M2 money supply. Additionally, the more people there are in the economy, the more money is needed to produce the same effect. So I have divided real M2 money supply by the total U.S population, leaving us with real per capita M2 money supply. That’s a bit of a mouthful, so I’ve shortened it to simply RPCM2.

In the chart below is plotted the annual change in RPCM2 over the last thirty 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 the year before. Over the thirty year period, RPCM2 grew at an average annual rate of about 2 percent which means that the line will spend more time above zero than below it. For that reason, a seven-year moving average line is also plotted on the chart.

When RPCM2 falls below its moving average for an extended period of time we label that period a BUST. If above the average, the period is labeled a BOOM. In the two boom periods, stocks as measured by the S&P 500 index averaged over 15 percent per year in capital gains appreciation (dividends excluded) after subtracting inflation. In the two bust periods, stocks depreciated in value by more than 1 percent. The lesson is clear: money 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 of easy money in stocks may now be behind us.

But there’s more bad news. There have been three times in the past thirty years when RPCM2 fell rapidly from lofty levels down through its moving average. These events are labeled with the letters A, B, and C in the chart.

The worst bear market since the Great Depression accompanied money slide A in 1973-74. During that market decline, the S&P 500 Composite index lost over 47 percent 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. Another two months hence and the now infamous Crash of 1987 helped erase nearly 35 percent of S&P share values. Taken together these two market declines represent the two worst bear markets over the 30 years under study. In both cases, stocks continued to fall until their respective money slides reversed.

The most recent slide C has thus far seen a decline of 35 percent in the hyperactive NASDAQ Composite index. The large cap indexes on the other hand have suffered very little. It is certainly possible that the bear market of 2000 is already behind us. But in the two previous money slides, the majority of the damage was done while RPCM2 lingered below its moving average.

Posted April 2000

Read the version published in Barron's here.

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