M3 Money Supply: Support of a Different Kind

May 23, 2004

In general, when one thinks about support in a market it usually means the last place where there was significant buying pressure as in "the stock market pulled back and I bought at support." But the support I am going to talk about today is of a more stealthy nature -one that isn't so readily apparent on the price chart, and that is the M3 money supply.

This isn't going to be a discussion about the in-appropriateness of the actions of the Federal Reserve or the future ramifications to our financial health of a hyper inflating broad money supply. Those concerns have been well documented elsewhere. This is about how trends in the M3 money supply affect trends in the stock market. "Holy Bubble, Batman - I thought the Fed didn't manipulate the markets!!!"

The M3 money supply is a broad measure of money and is an estimate of the entire supply of money within an economy, and thanks to the easy monetary polices of an Alan Greenspan led Federal Reserve, M3 has now expanded to new all time highs. Figure #1 (next page) is a weekly chart of M3 money supply. Measured in billions of dollars, M3 has more than doubled since 1995, and it has increased approximately $250 billion this year alone or about 9% annualized. Or put another away, the policies of the Federal Reserve will create almost $1 trillion (you read that correctly) this year alone to the broad money supply.

Interesting but from the looks of the chart it appears this has been going on for a long time and being that the overall trend has always been up, how can we use this information to prosper in the stock market?

Returning to figure #1, the middle plate is an indicator that measures rate of change. In this case, it compares the value of M3 today to average values at several points over the previous year. This produces an indicator that is blended (several points used), front weighted (preference given to recent data) and relative (compares "apples to apples"). Therefore, using this indicator, I can determine if the growth of money supply is decreasing or increasing. However, what I am really interested in is changes in the trend of money supply growth and how these changes correlate to prices in the stock market.

Figure #1/ M3 Money Supply/ weekly

To determine the trend in the changes of money supply growth I applied pivot points to the indicator in the middle panel. If the value of the indicator exceeded the slope between 2 pivot points or closed above two prior pivots, the trend was considered to be up. Down trends are reversed. The indicator in the bottom panel of Figure #1 is a graphic representation of the trend in growth of the M3 money supply. A value greater than zero means the trend is up; zero is neutral and below zero means the trend is down. You can see in the chart I highlighted a couple of the trend changes in orange.

Ok now that that is done, the big question is how do the trend changes in money supply growth relate to the stock market? First let's put a simple trading strategy together utilizing the NASDAQ market data going back to 1987. For a long trade, buy the market when the trend in money supply changes to up and sell the market when the trend changes to down. For a short trade, we will sell the market when the trend changes to down and cover the position when the trend in money supply changes to neutral (owing to the long side bias in the stock market). On the long side a 12% stop loss was used, and on the short side, an 8% buy stop loss was used. The results of these two systems are shown in the following table:

* profit factor= gross win/gross loss

** Rina Index=reward to risk ratio per unit of time in the market; should be > 30

Interesting results from two pretty simple systems- maybe not the best trading results but profitable nonetheless. May be this is another reason not "to fight the Fed."

The other interesting thing to look at in terms of Federal Reserve manipulation is the number of times the trend in money supply changes upward when the stock market is trending downward. To define a downtrend in the stock market I utilized the concept, which I have developed, of Price Structure Analysis. This is graphically displayed in the middle panel of figure #2, which is a weekly chart of the NASDAQ. When the graph is equal to -2 the trend in the market is down. Currently, the trend is down, and you can see how well this indicator did at identifying a downtrend from September, 2000 to March, 2003. By this indicator, there have been 18 unique times where the trend in the NASDAQ has turned down since 1987; in 15 of these cases the trend of the rate of change of the M3 money supply changed to upward during the downtrend in the stock market (bottom panel of Figure #2). Can we say, "the fed is goosing the markets"? Is this the evidence for that stealthy, unseen support on the price chart?

Figure #2/ NASDAQ/ M3 money supply (hidden)/ weekly

Other evidence, although not as compelling, is the percentage of time the trend in the rate of change in the M3 money supply has been upward pre- and post bull market. From 1981 to 2000, the M3 trend has been up about 32% of the time; since 2000, with the Federal Reserve fighting the bear with all its might, the trend has been upward 37% of the time.

But going back to our trading system, it clearly performed better during the bull market. The draw downs were about half those during the bear and the percentage of winners was much greater. During the bull, the long trade had 74% winners, but during the bear, only 44% were profitable. Of the 5 losses since 2000, all 5 were by the 12% stop loss; during the bull market, 5 out of the 6 losing trades were for losses less than 3%. So the questions are: is the Fed losing the battle against the bear and what can we take away from this for today's market?

From all the data presented, it appears that the Federal Reserve through manipulation of the money supply provides support to the stock markets. (I am not going to argue the timing of these infusions of money and rising stock prices, but I think a correlation exists.) Money supply goes up as the trend in the stock market goes down. Since 2000, the Federal Reserve has increased M3 money supply at an alarming rate, yet it appears that this did little good during the bear market. Most of these trades were losers.

The current situation is a downtrend in the NASDAQ and an uptrend in the M3 money supply. If this is a bull market, there is no doubt that the manipulations of the Federal Reserve would provide a floor to this market and prices should stabilize and go higher. If the bear market is returning, I suspect we will get a clue here if prices trade lower in the face of ongoing Federal Reserve monetary manipulation and support.

By many measures, the stock market is oversold to historical levels. Is this an oversold market that stays oversold in the way the March, 2003 market got overbought and stayed that way for months? Or will the markets find support and buyers to head higher making this look like the buying opportunity of a lifetime?

The term “carat” comes from “carob seed,” which was standard for weighing small quantities in the Middle East.