Over multiple decades, investors would struggle to find a more consistent creator of wealth than Wall Street. But trying to predict directional moves in the Dow Jones Industrial Average (^DJI -0.86%), S&P 500 (^GSPC -1.26%), and Nasdaq Composite (^IXIC -1.53%) over shorter spans is a guessing game.
Truth be told, there is no such thing as an economic indicator or predictive tool that can gauge, with 100% accuracy, which direction stocks will move next. There are, however, select data points that have strongly correlated with moves in the Dow Jones, S&P 500, and Nasdaq Composite. One such recession-predicting indicator is making a historic move right now, and it points to a very clear outcome for stocks.
Image source: Getty Images.
This has happened only three times in 50 years
Among the multitude of economic data points to comb through, it’s commercial bank credit that stands out as the potential tell-all for the U.S. economy and Wall Street.
Commercial bank credit is a figure reported weekly by the Board of Governors of the Federal Reserve. It encompasses securities held by U.S. commercial banks, such as mortgage-backed securities, as well as various loans and leases, such as residential and commercial real estate loans, along with consumer loans (e.g., credit cards and auto loans).
Since commercial bank credit was first reported in January 1973, it’s been fairly steadily increasing. This reflects the desire of banks to lend and/or generate interest income to offset the costs associated with taking in and holding deposits, as well as the fact that the U.S. economy expands over time. In other words, higher aggregate lending is expected.
Warning signs for the U.S. economy and stock market emerge when this relatively steady incline in commercial bank credit comes to a halt.
U.S. Commercial Banks Bank Credit data by YCharts.
Since 1973, there have been multiple instances of a fractional (less than 1%) decline in commercial bank credit from an all-time high. However, there have only been three instances in the last 50 years when commercial bank credit has dipped 2% or more:
- A peak decline of 2.09% during the dot-com bubble in October 2001.
- A maximum drop of 6.94% following the financial crisis in March 2010.
- The current 2.02% pullback from the mid-February 2023 high.
The main takeaway from the current decline, which does somewhat correlate with the short-lived regional banking crisis from earlier this year, is that banks are tightening their lending standards and becoming pickier with how they lend money. This combination of tighter lending practices and rapidly rising interest rates typically bodes poorly for U.S. economic growth.
It’s generally not good news for stocks, either. If it becomes tougher to access capital, or if borrowing becomes pricier, businesses usually respond by slowing hiring, acquisitions, and innovation. In short, it’s a net negative for corporate earnings.
Historically, there have only been four instances when commercial bank credit has fallen by at least 1.5% from a recent high: the aforementioned three instances, as well as 1975. All three previous instances were associated with a roughly 50% decline in the benchmark S&P 500. Although no economic data point can concretely predict the future, this historic decline in commercial bank credit suggests a U.S. recession is on the horizon, and downside is likely for stocks.
U.S. money supply is making history, too
Interestingly enough, it’s not just commercial bank credit that’s making history. We’re also witnessing a move in U.S. money supply that hasn’t happened since the Great Depression.
The two commonly followed money supply metrics are M1 and M2. The former accounts for cash and coins in circulation, as well as demand deposits (e.g., checking accounts). Meanwhile, M2 factors in everything in M1 and adds savings accounts, money market accounts, and certificates of deposit (CDs) below $100,000. It’s this latter figure, M2, which is raising eyebrows.
Similar to commercial bank credit, M2 money supply is expected to increase without much interruption over time. An expanding economy should require more cash and coins to facilitate transactions. But on the rare occasions where meaningful declines in M2 money supply have occurred, trouble has followed.
WARNING: the Money Supply is officially contracting. 📉
This has only happened 4 previous times in last 150 years.
Each time a Depression with double-digit unemployment rates followed. 😬 pic.twitter.com/j3FE532oac
— Nick Gerli (@nickgerli1) March 8, 2023
When back-tested to 1870, there have been only four previous instances where M2 money supply declined by at least 2%: 1878, 1893, 1921, and 1931-1933. All four of these instances resulted in deflationary depressions and high unemployment rates. As of September 2022, M2 money supply is nearly 3.9% below its all-time high, marking the fifth meaningful decline in its history.
To be fair, a whole lot has changed since these four prior downturns in M2 money supply. Two occurred before the creation of the Federal Reserve. Further, the nation’s central bank is far more knowledgeable on how best to approach a challenging economic climate today than it was 100 years ago. A depression with a double-digit unemployment rate is highly unlikely today.
Nevertheless, a sizable decline in M2 isn’t something to be overlooked. With core inflation remaining stubbornly high, less capital in circulation likely means fewer discretionary purchases. As with commercial bank credit, M2 money supply appears to point to a coming recession and weaker performance for the Dow Jones, S&P 500, and Nasdaq Composite.
Image source: Getty Images.
Patience pays off handsomely on Wall Street
While “following the money” would appear to bode poorly for investors in the short term, patience has a way of paying off handsomely for those with a long-term mindset.
Take the stock market’s ups and downs as a perfect example. Since 1950, the benchmark S&P 500 has endured 39 double-digit percentage declines. Even though these drops often surprise investors, they’re a perfectly normal part of the investing cycle.
Equally normal is the fact that every major decline in the Dow Jones, S&P 500, and Nasdaq Composite, save for the 2022 bear market, has eventually (keyword) been cleared away by a bull market rally. Despite never knowing precisely when downturns will occur or where the ultimate bottom may be, historical data is pretty conclusive that the major indexes point higher over long periods. This makes any significant downturn a seemingly surefire buying opportunity.
Something else to consider is that downturns in the U.S. economy aren’t proportional to periods of expansion.
Since the end of World War II, the U.S. has navigated its way through 12 recessions. Only three of these economic downturns have lasted at least 12 months, with the remaining three failing to surpass 18 months. By comparison, most periods of expansion have lasted multiple years, with one continuing for a full decade.
The key point is that corporate earnings are going to expand in lockstep with the U.S. economy over the long run. Any near-term turbulence in equities is a blessing in disguise for opportunistic long-term investors.
