 Stalling
Monetary Growth
Adam Hamilton
Archives
February 28, 2004
In the financial markets, the
bulls and bears can seldom manage to agree on anything. Take
any number at all, it seems, and both the bulls and bears can
easily interpret it to bolster their own particular worldview.
High stock valuations? No
problem, say the bulls, as valuations should be high when interest rates
are low. The bears, on the other hand, see this exact same
valuation data as a
dire warning of the coming second phase of a brutal Great
Bear market barreling down upon us with a vengeance.
The falling dollar? Great
for the American stock markets, claim the bulls, as it enables
US industry to export into the world markets at far more competitive
prices. The bears perceive things a bit differently though,
seeing the ongoing dollar
bear as an enormous negative for equities since it makes
earning profits vastly more difficult for foreign investors who
wish to bid up the US stock markets with their precious capital.
Amazingly enough however, there
is at least one area in which the bulls and bears are able to
miraculously set aside their deep fundamental differences and
reach a tentative agreement. Neither side will dispute that
a rocketing money supply tends to boost equity markets over the
short term.
When money supplies are growing,
all of the fresh money created by the Fed has to find a home
somewhere. With relatively more money chasing after relatively
fewer goods, services, and investments, the prices of these things
inevitably rise. A deluge of new money tends to lift the general
stock markets in a massive inflationary tide, at least initially.
Over the long run, however,
monetary inflation slaughters the stock markets as we witnessed
in the 1970s and early 1980s, when they fell to 7x earnings.
After a long enough period of central bank promiscuity in monetary
growth and depredation of savers, investors flee paper assets
into real inflation-proof assets like gold and silver. But early
on in an inflationary campaign, before the mortal
threat to savers is widely perceived, stocks tend to thrive
in the liquidity flood.
If a rapidly rising money supply
tends to boost stocks for a short euphoric season, then what
would a falling money supply portend? It probably would not
be good, as relatively less money chasing after relatively more
goods, services, and investments would lower the prices of everything,
including stocks. We have not witnessed deflation
in the States since the Great Depression though, and the Fed
will probably print money until its printing presses melt rather
than risk traveling down that feared and loathed path once again.
While shrinking money supplies
are exceedingly rare in countries with fiat-paper currencies
that they can expand continuously, it is possible to see vast
reductions in the growth rates of the paper money supplies.
Economists use the term disinflation
to describe a deceleration in the growth rate of a money supply.
Provocatively we are now experiencing
a disinflation in monetary growth in the United States. If an
acceleration of inflation tends to initially lift stocks on a
deluge of new money, what will a deceleration of inflation bode
for the general US equity markets? Odds are that we are all,
bulls and bears alike, going to find out in 2004!
Our pair of charts this week
highlights the stalling US monetary growth compared with the
flagship S&P 500 stock index. The first graph looks at the
broad M3 monetary measure, while the second explores the much
narrower MZM monetary gauge. The yellow line shows the annual
year-over-year growth rate in each money supply, while the red
line highlights their respective absolute growth (not annualized)
over 10 weeks.
Both of these key US money
supplies have witnessed a drastic slowdown in growth in the past
couple of years and stock investors really need to carefully
consider just what the potential impact on the equity markets
from this rare development might be. With less monetary fuel
to burn will stocks be able to continue their soaring rally?
Broad M3 monetary growth has
slowed dramatically, falling from over 13% year-over-year in
2001 down to merely 4% today. The shorter 10-week growth measure
has also decreased substantially, bleeding from 4% or so in 2001
down to nearly nothing today. The descending dotted arrows above
for both monetary growth measures are precise linear mathematical
trends of the data, highlighting the degree of disinflation in
monetary growth in the US today.
Now there is no disputing that
money supplies are pretty arcane and esoteric stuff. Unless
you happen to be a practicing economist or total market junkie
like me, odds are that you haven't wasted much of your life even
thinking about money supplies, let alone investigating the actual
data. Thus, it is very important to realize just how incredibly
rare a rapidly decelerating monetary growth environment truly
is.
In last summer's "Inflation or Deflation?
2" essay, the second graph shows the actual US M3 and
MZM money supplies, the same measures used in today's graphs,
back to 1960. The only time in this entire span that money supply
growth slowed down considerably was in the early 1990s. Other
than this one episode, there really isn't another time in modern
history when money supply growth slowed as dramatically as it
has today. You can see another zoomed in view of the early 1990s
M3 growth rates in the first graph in "M3
Growth and Stocks" if you wish.
Decelerating monetary growth,
disinflation, is an abnormal state of events, a strange anomaly
in an otherwise relentless rapid rise in money supplies in a
fiat-currency regime. As such, any time that this growth rate
in money stalls significantly, investors need to take note and
carefully consider the potential consequences of such a rare
development.
In annual terms, a 4% M3 year-over-year
growth rate is unbelievably low. From January 1995 to March
2000 for example, the bubble years where US stocks rocketed higher,
M3 grew at an average annual rate of 7.8%, which is highlighted
above for reference. From April 2000 to the present, even including
today's current very low monetary growth numbers, M3 grew at
an even higher average annual rate of 8.7%, also drawn above.
Monetary growth accelerated
during the brutal Great Bear bust as Greenspan and the Fed desperately
tried to do everything possible to reinflate a doomed stock-market
bubble to bailout overextended stock-market speculators. It
peaked above 13% in late 2001 right after the sharpest stock-market
plunge in the entire bear market to date. The Fed
panicked right after 9/11 and pulled out all the stops to
force feed excess capital into the system to stave off the threat
of a massive crash.
As the annual monetary growth
rate slowed significantly in 2002, the stock markets continued
to plummet. The markets didn't really stabilize in late 2002
until the money supply growth rate itself stabilized and stopped
falling. Interestingly, the war rally in US equities launched
last spring also corresponded with another sharp increase in
the YOY growth rate in M3. This relationship held well until
mid 2003, when money supply growth and the stock markets suddenly
decoupled.
The S&P 500 kept rocketing
higher in the final quarter of 2003, but the rate of growth of
the broad money supply continued to contract. This is quite
a startling anomaly, since a slowing monetary growth rate restricts
the injection of new capital into the financial system and makes
it much more difficult for the general stock markets to rise.
If I was long general equities right now, which I am certainly
not, I would be very troubled to see stocks decoupling with monetary
growth rates in the US.
The red 10-week growth line
is showing the same strange phenomenon on a shorter scale. The
short-term rate of growth in M3 is declining significantly as
well. While negative growth rates over 10 weeks were relatively
rare and far between a few years ago, now the 10w M3 growth rate
is spending more and more time below zero.
It is provocative that this
rate's mathematical linear trend, the descending dotted-red line,
is due to punch under zero sometime in April or May. Whether
you have a bullish or bearish bias, it is hard to imagine how
a contracting broad US money supply over the short-term could
be anything but negative for today's vastly overvalued and speculative-froth-laden
US equity markets.
Before we move on to MZM, there
is another weird development that caught my eye in the 10w M3
growth line. Generally, money supply growth spikes in Q4 of
each year. The Fed ensures that retailers and consumers have
lots of money available for the all-important Christmas shopping
season, so there are usually big spikes in monetary growth in
Q4. On the chart above you can see these red Q4 growth spikes
at the end of 2001 and 2002.
Strangely, at the end of 2003
there was no typical spike in M3 growth. During the first part
of Q4 of last year 10w M3 growth was actually negative, shrinking,
and only during late November and December did this key growth
rate struggle back into mildly positive territory. I am not
sure how to interpret this data, but it is really odd and unexpected
not to see a big Q4 monetary growth spike at the end of 2003.
Perhaps the lion's share of Q4 2003 gift buying was done on
credit alone, as US consumers struggled to use actual money to
purchase their gifts.
Moving on, the narrower MZM
money supply is much more relevant than the broad M3 in terms
of monetary impact on investment assets like stocks. MZM is
available to be deployed quickly and not tied up in long-term
savings instruments like a large fraction of M3. As such, stock
investors should pay even more attention to recent MZM developments.
As this second chart illustrates,
the deceleration and disinflation of MZM growth has been even
far more extreme than the same phenomenon in M3 above. In MZM
we see the same general chart topography as we saw in M3, including
the sharp slowdown in monetary growth, the recent decoupling
of stock prices and monetary growth trends, and the mysterious
lack of a Q4 2003 retailing growth spike. Only in MZM terms,
all of these events are underway on a much larger and more volatile
scale.
Narrower MZM money is far more
volatile than the broader M3 money supply. Even when this increased
volatility is considered though, the slowdown in MZM is nothing
less than breathtaking. Annual MZM growth peaked near a mind-blowing
22% after 9/11, banana-republic inflation levels, and has now
plummeted to only 3% or so, an extraordinary rate of decline
in only a couple of years.
The descending yellow dotted
line highlights the steep downward slide in MZM growth's mathematical
linear trend. To gain a point of reference from which to understand
just how anemic 3% annual MZM growth really is, we drew in two
yellow reference lines above. From January 1995 to March 2000
during the bubble years, annual MZM growth averaged 7.5%. During
the following bust from April 2000 to today, annual MZM growth
averaged 11.0%.
So today's MZM growth rate
has plunged to less than half of the "normal" MZM growth
rate that fed the bubble years of the late 1990s and just over
a quarter of the soaring MZM growth rate that the Fed used to
try and retard the bust years. We are really entering uncharted
territory in MZM disinflation here, as we have not yet seen the
effects of such lethargic MZM growth on a hyper-overvalued stock
market right after a Great Bubble burst and bust. Interesting
times!
The 10w MZM growth rate is
decelerating dramatically as well, having fallen from 6% in 2001
all the way down to -1% today. Yes, MZM is actually shrinking
now on a 10-week scale, not merely disinflating but actually
deflating! A deflating MZM money supply over the short-term
ought to terrify stock investors, as the more the pool of available
hot money for investment contracts the greater the headwinds
the US markets will face in clawing higher.
The 10w MZM growth rate's mathematical
linear trend has just crossed into negative territory as well,
suggesting that shrinking MZM on a 10-week scale is here to stay
unless something dramatic happens to money supply growth in the
US. Shrinking monetary environments are certainly not conducive
to farther fantastic gains in the American equity markets!
The massive decoupling between
the rate of monetary growth and the short-term trend in the US
stock markets at the end of 2003 is even more apparent in MZM
terms. The final upsurge in the blue S&P 500 and the final
plunge in the yellow MZM year-over-year growth rate look like
mirror-image opposites on the right side of this chart. I would
be really surprised if such an enormous divergence of monetary
growth rates and stock gains can persist for much longer.
Armed with some fresh data
and perspective, we can return to our original question. Bulls
and bears both agree that monetary growth, particularly accelerating
rates of monetary inflation, generally yields a short-term boost
to the equity markets as relatively more money chases after relatively
fewer goods, services, and investments.
But if accelerating inflation
is good for stocks over the short-term, shouldn't decelerating
inflation or even deflation be bad for stocks over the short-term?
After all, if the pool of money available to chase goods, services,
and investments is growing much more slowly or even shrinking,
shouldn't stock prices have to fall to reflect the reduction
in capital bidding on them?
While I can't help but have
a bearish bias on the US equity markets myself since they are
still trading near historic bubble
valuations in trailing PE terms, I cannot see how even the
most incorrigible perma-bull can interpret these troubling monetary
disinflationary developments in anything but a negative light.
A rapidly rising stock market
that is already greatly overvalued can only go higher if ever
increasing amounts of capital bid on and chase stocks higher.
A speculative mania mentality possesses investors and speculators
and they cease to worry about buying stocks low, but instead
they just merrily buy at any price and hope to sell to a greater
fool later.
When this mania mentality arrives,
the stock markets become more of a Ponzi scheme than an arena
for buying truly undervalued companies in valuation terms and
riding them to long-term investment profits like Warren Buffett
would. In a Ponzi scheme, the folks fortunate enough to get
in early make lots of money, but as soon as the scheme grows
large enough so that the rate of new capital introduced into
it tapers off, the whole scheme implodes.
We could certainly witness
a similar reckoning in the US equity markets. If the slowing
growth rates in money supplies lead to an environment where there
is simply less fresh capital flooding into the equity markets,
stock prices will no longer spiral higher on an increasing tide
of new bids. As demand for stocks peaks and then falls, stock
prices will have no choice but to correct, possibly quite aggressively.
A reduction in the rate of money pouring in could flash the
Game Over signal in equity-land, the point at which farther gains
rapidly become impossible.
On a side note, this stalling
monetary growth inevitably spawns discussions on the Fed. Since
the Fed is responsible for growing the US money supplies, many
people including me wonder if the Fed has purposely engineered
this monetary disinflation or if forces beyond its control are
dragging money-supply growth rates ever lower contrary to its
will.
If the Fed is doing this on
purpose, I can't understand what its motivation would be. Ever
since the bubble burst in 2000, the Fed has done nothing but
try to bailout overextended stock-market speculators who foolishly
trapped themselves in the bubble and crash. If the Fed is suddenly
tightening money supply growth, it has to know that it has a
high probability of killing the nearly year-long rally in US
equities by turning off the inflationary liquidity spigot.
On the other hand, if the Fed
is losing control of the money supply, what could be causing
the rapid reduction in US monetary growth rates? If interest
rates were rising already, we could probably assume that debt
defaults were accelerating, as declining debt levels have a multiplied
effect on money and credit levels in an economy dominated by
fiat currency and fractional-reserve banking. But with interest
rates holding at brutal 45-year lows, debt defaults have probably
not yet been pummeling monetary growth rates since 2001.
Another fractional-reserve
banking possibility is that the debt market is saturated. With
consumers and corporations deep in debt up to their ears after
the Fed encouraged them via unnaturally suppressed short-term
interest rates, perhaps there is little interest or capacity
for more borrowing. Additional borrowing increases money supplies
through the fractional-reserve multiplier effect, so lower borrowing
could reduce monetary growth rates.
So while I really doubt that
the Fed would intentionally eviscerate its monetary inflation
rates in such a fragile post-bubble environment, I haven't yet
reached a firm conclusion on exactly why the Fed could be losing
control of monetary growth rates either. I hope that the causes
behind these surreal monetary events will become clearer as 2004
rolls on, but for now they remain rather mysterious.
Can a powerful rally in US
equities continue marching northward even in the face of stalling
monetary growth rates? Can stocks soar even higher while disinflationary
forces dry up the deluge of liquidity that they so desperately
need for fuel?
Only time will tell, but if
I was long the hyper-overvalued US markets like the bulls are
here, I would sure be nervous after looking at these stalling
monetary growth charts!
Adam Hamilton, CPA
email:
zelotes@zealllc.com
Archives
February 27, 2004
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