Are changes in the money supply usefully predictive of stock market behavior? In his September 2014 paper entitled “Does Money Supply Growth Contain Predictive Power for Stock Returns?”, David McMillan investigates whether changes in U.S. money supply reliably affect future U.S. stock market returns. He examines also whether any predictive power of money supply growth is independent of dividend yield, interest rates and other economic variables. He focuses on M2 money stock but also considers M1 money stock and the non-M1 components of M2 (saving deposits, small time deposits, retail money market mutual funds), M4 and the monetary base and its components (currency in circulation and reserves). He considers predictability horizons of one month, one year, five years, 10 years and 15 years. Using monthly data for stock index levels, dividends and earnings from Robert Shiller and seasonally adjusted money supply and other economic data from FRED during January 1959 through December 2012 (54 years), he finds that:
- Based on in-sample regressions, M2 money stock growth relates:
- Negatively and significantly to future stock market returns at horizons of one to 10 years.
- Negatively but insignificantly to future monthly stock market returns.
- Positively to future 15-year stock market returns (significantly so for pre-2007 data).
- Results are similar for most alternative money supply measures .
- Money supply growth has predictive power for intermediate-term stock market returns over and above that from financial ratios (such as dividend yield), inflation, interest rates and industrial production.
- Results are most consistent with an interpretation that high money supply growth reduces risk and therefore expected returns via association with lower interest rates, lower firm debt and improved economic outlook.
- Based on out-of-sample rolling 120-month regressions:
- At a one-month horizon, the historical mean performs as least as well as models based on predictive variables, including money supply growth.
- At a one-year horizon, a model employing all predictive variables including money supply growth beats the historical mean except around the dot-com bubble and during 2012.
- At a five-year horizon, a model employing all predictive variables including money supply growth consistently beats the historical mean.
- Money supply growth consistently adds predictive power to models based on other predictive variables.
In summary, evidence indicates that money supply relates negatively to future stock market returns at intermediate-term horizons by making the environment easy for corporations and thereby suppressing the equity risk premium.
Cautions regarding findings include:
- The 54-year sample period is short for examination of stock market returns at horizons of five to 15 years (only about four to 11 independent measurement intervals).
- Shiller’s monthly stock index levels are averages of daily levels for the month and not month-end values. This blurring may materially interfere with any relationship between money supply growth and stock market return at a monthly horizon. Delay in data availability (roughly two weeks) is also likely material for a monthly relationship.
- The study does not include tests of the economic value of the relationship between money supply growth and future stock market returns. In other words, it does not include tests of any market timing strategy based on money supply growth.
- The methodology assumes a linear relationship between money supply growth and future stock market returns. There may be a material non-linearity in the relationship.
See also “Money Supply (M2) and the Stock Market”, “Money Supply (M1) and the Stock Market” and “Money Velocity and the Stock Market”.
