There is a new plus that is more powerful than temporary tax
rebates and much healthier than outsized federal spending increases. The
broad U.S. money supply has started to pick up significant steam in recent
weeks, leading to an 11 percent annualized growth in the just-ended third
quarter. It's the fastest money pace in a year.
Specifically, Milton Friedman's M2 -- the money measure that
takes into account currency, checking accounts, money market funds and
savings accounts -- could be signaling a big economic pick-up next year, a
very bullish development for stocks. While M2 is certainly not an infallible
indicator of economic trends, historically it links to current and future
changes in national income. So it is worth watching.
M2 correctly warned last winter and spring that economic trends
were slowing down in 2002 after a notable economic rebound in late 2001. The
surprising post-9/11 economic recovery was accompanied by a near-25 percent
stock market rally that completely contradicted wartime pessimism. This was
preceded by a doubling of M2 growth -- it moved up to 12 percent by year-end
from 6 percent 12 months earlier.
Of course, the Fed helped matters along by cutting interest
rates 11 times last year, thus growing the supply of high-powered cash by
about 12 percent (not including the Fed's significant 9/11 money-adding
This year, however, monetary trends turned down. Monetary-base
growth, which fuels M2 growth (in Friedman theory), trended down to 5
percent or 6 percent by the middle of 2002. Presently it is growing about 7
Meanwhile, M2 growth, which in some sense measures the use of
Fed cash, tumbled all the way to 2.5 percent by early June this year from 12
percent in the late fourth quarter of 2001. In general terms, this
surprising drop seemed to carry the stock market down with it. Earnings
estimates were brought down. And new gloom over future economic growth
Yet since bottoming around midyear, money has turned up
significantly. This is a very good sign. One wonders if the stock market
bottom of late July is somehow picking up the upturn of M2 growth.
Tax-rates are a bigger economic influence than money over the
longer term, especially with respect to incentivizing output, productivity
and investment. But money is key in the shorter run. And it has definitely
become more generous.
So, if this positive money-reading is in fact accurate, then we
are headed for a substantial stock-market rise that will not be less than 15
percent or 20 percent and could be as much as 40 percent among the major
averages. Indeed, a pre-election stock rally may have already begun.
Whether Friedman M2 is a leading indicator, or a coincident
indicator, or a little of both, its recent recovery spells good news. It is
just that simple.
But we haven't yet seen a clear confirmation of monetary
stimulus from solid gains in gold and industrial metals. Nor have we seen
clear liquidity-adding signs in Treasury market rates, or corporate bond
market evidence that profits and credit quality are definitely on the mend.
For these reasons, the Fed should still pump more cash into the
financial system with another interest rate cut. This would ensure that
Friedman M2 growth stays aloft in the months ahead.
Unfortunately, neither President Bush nor Democratic
congressional leaders have proposed an investor tax-cut package to boost
stock values by relieving the double-taxation burden on dividends. However,
Ways and Means chair Bill Thomas has proposed a $5,000 increase in the
investment loss deduction, along with a 75-year-old age limit for 401(k)
retirement redemptions and an acceleration in supersaver contribution
increases. These are good ideas that could pass the House, but they will not
get through the Senate.
So that leaves the money story. Money matters. It matters for
consumer activity, investment and the growth of this economy. Couple this
money surge with the strong bipartisan Iraq war resolution that sends the
right signals to our U.N. friends and our Mideast terrorist enemies, and the
picture looks to brighten substantially. The economy is not as strong as it
should be, but it's still better than naysayers would have us believe.
Nonetheless, incumbents better beware in the midterm elections. The investor
class is not a happy camper.