Copyright © 2003 by Norman P. Poire. All rights reserved.

By Norman P. Poiré

Thirty-seven months ago I warned readers of Barron's that "the days when investors could count on making easy money on Wall Street are gone, at least for now" (The Money Effect, August 28, 2000). My angst had been triggered by a bearish indication from RPCM2, a proprietary indicator I introduced in that same article.

Days later, the benchmark S&P 500 Index formed an important double top just north of 1500. From there equity share prices ground lower in unrelenting fashion for more than two years as the value of the S&P 500 was cut in half.

Since October of 2002, however, stocks have been in a cyclical bull market that has thus far recouped 1/3 of those losses. So the "easy money" days for investors are back -- but for how much longer?

The answer to that question hinges a great deal on the underlying, or secular, trend of the stock market. While cyclical bull and bear markets are normally measured in months or years, secular trends can last up to two decades. If the 2000 market peak ushered in a secular bear market, then this cyclical bull market should be viewed as a selling opportunity.

The powerful secular bull market that began in August 1982 was pretty long in the tooth when the 2000 cyclical bear took hold. That alone should make us wary that a major long-term change in trend may be underway. Traditional valuation measures such as price/earnings ratio and stock dividend yield are also flashing caution lights.

What really has me concerned, though, is the message that RPCM2 is conveying.

Allow me to quickly review how this indicator is calculated. The basic building block of RPCM2 is M2 money supply, which includes, among other things, currency in circulation, checking accounts, savings accounts, and money market funds.

By itself, M2 is a measure of liquidity in the economy. My research indicates, however, that this economic variable is more useful when it is divided by both the consumer price index and total U.S. population. The resulting real per capita M2 money supply, or RPCM2 in shorthand, tells us how much money in real terms each of us has to spend on average.

When RPCM2 occupies a lot of time above its seven-year moving average as it did from 1981 to 1987 and again from 1994 to 2000, the stock market tends to enjoy a period of plenty. In between these booms when RPCM2 is mostly below its moving average, like from 1973 to 1981 and again from 1987 to 1994, financial scarcity tends to rule.

Notice I use the word "tends" to describe the relationship between available liquidity and stock market performance. As is the case with most any stock market correlation there can be some glaring exceptions.

At times the economy can be running low on liquidity yet the stock market attracts more than its usual share of dollars. When share prices rise even as RPCM2 falls, that's a positive divergence. There are other times when the economy is awash in money but investors find better values outside the stock market. That creates a negative divergence.

It's not these divergences themselves I want to draw your attention to but rather what happens after them.

In the chart below, I have plotted both the year-over-year percent change in the S&P 500 Index and the year-over-year dollar change in RPCM2 for the last four decades. I think you'll agree that with the exception of the four highlighted areas, the two measures move together reasonably well.

Data sources: Standard & Poor's, Federal Reserve Bank of St. Louis.
Check the latest RPCM2 chart.

The first highlighted area represents a negative divergence when stocks under performed RPCM2. This was a warning to investors that there was considerable underlying weakness in equities. When the two measures reasserted their convergent ways, stocks headed south in one of the toughest bear markets on record, selling off -39% over one twelve-month period.

The next two highlights mark periods of positive divergence that foretold of very powerful bull markets to come. Once RPCM2 got on the same page with stocks, twelve-month gains in the stock market of +53% and +44% followed.

In all of these divergences it was equities that ultimately trumped RPCM2. That's an important conclusion to draw because since July of 2000 stocks have greatly under performed RPCM2. With history as prelude, it's a safe bet that the current bull cycle is ready to give way to a bear cycle that could eventually produce twelve-month losses in the vicinity of -50%.

Were the S&P 500 Index to trade in the 500s or lower, the long-term chart would display a series of lower highs and lower lows. By definition that would affirm that the secular trend is indeed down and that the bear has simply been in a yearlong hibernation.

While I believe that investors would be wise to heed the warning from my long-term indicator, RPCM2 falls short as a precision timing tool. For that task I rely on an intermediate-term economic model that considers both long and short-term interest rates along with the price of gold and the CPI inflation rate.

Sell signals from that model have historically coincided within six weeks of important market tops. On August 22^nd a combination of rising long-term interest rates, gold prices, and inflation were enough to trigger its first sell signal since February of 2002.

Unless my model fails me, the stock market is set to peak some time before October 3^rd. That news is particularly troubling at a time when corporate insiders are unloading their shares in record numbers. Neither is it comforting to know that professional soothsayers who are bullish outnumber those who are bearish by more than three-to-one. As a group they haven't been this chipper since the summer of 1987.

Posted September 2003

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