Copyright © 2001 by Norman P. Poire. All rights reserved.

From 1978 until just recently, Congress required the Federal Reserve Board to set one-year targets for money supply growth and to regularly report them in congressional testimony. When the Humphrey-Hawkins Act of 1978 expired in July 2000, the Fed announced it would no longer set such targets. The rationale behind their decision had been explained some years before.

In 1993 Fed chairman Alan Greenspan speaking before Congress remarked, "The historical relationship between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place."

As Greenspan & Company were performing the last rites of the once celebrated indicator, I was busily working on an article entitled The Money Effect (Barron’s, August 28, 2000) which demonstrated a connection between RPCM2 and stock market performance.

RPCM2, short for ‘real per-capita M2 money supply’, is calculated by adjusting M2 money supply for CPI inflation and population growth. It is the number of constant-value dollars every man, woman, and child in the U.S. would have in their pockets and in their various checking, savings, and money market accounts if these liquid assets were divided equally.

July of 2000 was a watershed not only because of the abovementioned procedural change at the Fed. That was the month I concluded from my RPCM2 indicator that a new era was arriving for stocks — one in which profits would be much more difficult to come by.

It was also the month that the Fed, now officially unrestrained by Humphrey-Hawkins, embarked on a torrid expansion of the money supply that has since swelled RPCM2 to levels not seen since its recent peak of 1999.

In those ebullient days of just two years ago, liquidity eagerly found its way into the stock market. Not so in recent months, however. Lately we are getting far less bang for the buck than has historically been the case.

The following chart illustrates the tendency for the S&P 500 index of large capitalization stocks to move up when RPCM2 expands and to fall when RPCM2 contracts. Over the past twelve months that relationship has "largely broken down."

To be sure, there have been other instances in the past when the correlation between these two variables was less than stellar. What we are witnessing today, however, is the cusp of something unusual — a public awash with cash that is resisting plowing that wealth into equity shares.

That point is driven home when time is eliminated from the equation. This can be accomplished by plotting the year-over-year change in RPCM2 and the year-over-year change in the S&P 500 against each other rather than against time.

As you can see, most of the data points cluster around a line that has been "eyeballed" onto the chart. Over in the upper left hand corner are four months, all from year 2001, that have separated themselves from the pack by turning in the worst stock market performance of the last four decades when RPCM2 was briskly increasing.

When the public chooses to operate in this quadrant, it is bad news for equity investors. That’s because it means people are finding other places to put their dollars like into tangible assets or safer fixed income instruments or simply toward the retirement of debt.

I use RPCM2 as a long-term indicator precisely because it can break down in the short run and even in the intermediate term. When people have extra money in their pockets they have a tendency to funnel a portion of it into the stock market — but it is not guaranteed. There are times when for one reason or another public preferences will temporarily disrupt this normal relationship.

The 64,000-dollar question is ‘When the relationship reasserts itself, assuming that it does, will the market catch up with money or will liquidity follow share values lower?’

Back in 1977 stocks were nearly as immune to expanding liquidity as they are today. It was a period of high inflationary expectations when time horizons shortened and depreciating dollars chose tangible over financial assets. In the end this anomaly was resolved to the downside, with share prices slowly working their way lower as RPCM2 plummeted.

Prior history is no guarantee of future performance, as they say, but one has to wonder how a similar outcome can be avoided this time around. The driving force these days is deflation, not inflation. A capital investment boom that led to industrial overcapacity seems to be resolving itself with falling prices, shrinking profit margins, and tumbling share prices.

In the latest flow-of-funds report issued by the Federal Reserve, household net worth in the 1^st quarter of 2001 was down a full 8 percent from levels a year earlier — by far the worst performance in forty years.

A closer inspection of the numbers reveals that the entire loss in wealth can be laid at the feet of the stock market. Is there any wonder then that investors are quietly shunning equities and seeking safer places to put their money?

Posted August 2001

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