S&P 500 / M2 Money Supply

I don't see a rally here

Yesterday, I wrote a little bit about the recent stock rally and how I didn’t really have an explanation for it. Coincidentally, I saw a chart today that offered some compelling rationale. It’s constructed by taking the S&P 500 and dividing it by the M2 Money Supply:

The stock market looks very different when it is adjusted to account for the outstanding money supply. It’s a similar approach as dividing the market by GDP. However, unlike that metric, there hasn’t been nearly as big of a run up since the Financial Crisis.

Now, that’s all fine and well but the real question of the day is why the market has been rallying. The answer is all the way to the right at the edge of the most recent data. Do you see a spike there? I sure don’t.

There’s no spike because even though the market has gone up, the M2 money supply has exploded from all the trillions printed in new stimulus. Thus, the ratio has essentially been flat.

One explanation for the surge in stocks then is that the dollar has deflated relative to shares of stocks. That means it’s not so much that the market has had a big rally as it now takes more dollars to buy shares and thus the stock index has risen in dollar terms.

So, if you’re like me and have some cash that you had wanted to invest but didn’t for one reason or another, it’s worth a whole lot less than it was worth two months ago. That’s unfortunate.

The next question then, is how does this dynamic play out elsewhere in the economy? Is it that stocks have inflated but nothing else? Or will home prices, groceries, college tuition, and all the other things people spend money on inflate too?

Time will tell. But, I can say with a fairly high confidence that this phenomenon of a market close to an all-time high with sky-high unemployment and an increased dollar supply will likely lead to a further divide of wealth inequality. That’s definitely not something the world needs right now on top of everything else. But, here we are.