The premise of this journal is that the supply of money can diverge from the demand to hold it and the difference – "excess" or "deficient" liquidity – is a key driver of markets and economies.

Implementing the approach, however, requires an estimate of the demand for money, which is unobservable. A starting-point is to assume that underlying demand depends on the level of nominal economic activity. This implies that excess or deficient liquidity expansion will be related to the gap between the growth rates of the real money supply and output.

The chart shows an index of the return on developed-market equities in US dollars relative to the return on dollar cash (three-month eurodollar deposits). The index rises from 100 at the start of 1970 to 249 at the end of November 2009. In other words, equities outperformed cash by 149% over the forty years, or 2.3% per annum.

The shaded areas in the chart define periods when annual growth in Group of Seven (G7) real money supply – on the narrow M1 measure – exceeded the rate of expansion of industrial output, suggesting excess liquidity. Equities have tended to outperform cash during such periods while underperforming when real money lagged output.

On average, equities returned 11.1% per annum more than cash when there was excess money expansion and 5.8% less when liquidity was deficient. A strategy of switching between equities and cash depending on liquidity conditions would have yielded a cumulative excess return of 873% (5.9% per annum) versus the 149% (2.3%) from a buy-and-hold policy.

Interestingly, the results are less impressive when a broad rather than narrow money measure is used to identify the liquidity environment. On average, equities outperformed cash by 6.3% per annum when G7 real broad money was rising faster than output while underperforming by 1.8% at other times.

Changes in liquidity conditions sometimes bypass developed-market equities and have their main impact on other asset classes. For example, money growth shortfalls in 1994-95 and 1997 were associated respectively with G7 bond market weakness and the Asian crisis. Conversely, excess liquidity in 2001-02 propelled property rather than equity markets higher.

Based on partial data, G7 real M1 is likely to have risen an annual 8% in November versus a 6% fall in industrial output, implying still-favourable conditions. Real money, however, has fallen short of output growth over the last six months and the annual rates of change are likely to converge by next spring as economic recovery proceeds and headline inflation rebounds.

A tide of liquidity has lifted most boats this year but is beginning to ebb. This does not preclude a further rally in equities in 2010 but the ride is likely to be bumpier than in 2009 while a sustained advance may depend on cash shifting out of other asset classes, whose prices may suffer corresponding weakness.