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Monetarism rules OK

Posted on Wednesday, February 8, 2012 at 09:12AM by Registered CommenterSimon Ward | Comments2 Comments

The forecasting approach employed here relies on three simple “monetarist” rules:

  • The real money supply leads output by about six months.

  • The nominal money supply leads prices by about two years.

  • Markets do better when real money is growing faster than output.

The first two stem from the empirical work of Friedman and Schwarz – see also here – while the third is a monetarist market rule-of-thumb, based on the idea that faster growth of real money than output implies “excess” liquidity available to push up asset prices.

These simple rules have outperformed consensus predictions over the last year, continuing a longer-run record of success.

The first rule was the basis for a forecast here last autumn that global economic momentum would pick up into early 2012, in contrast to consensus worries of a US “double dip” and Eurozone implosion.

The second rule was used last spring to predict a peak in G7 inflation in autumn 2011 followed by a modest decline in 2012, a forecast that also appears on track.

The third rule forms the basis for an investment strategy discussed here previously, involving switching between equities and cash depending on whether the annual growth rate of G7 real narrow money is greater or less than that of industrial output. A conservative form of the strategy buys equities six months after a positive real money / output cross-over but sells immediately on a reversal.

The chart compares the historical return on this strategy relative to US dollar cash with that of buying and holding equities. The strategy has beaten buy-and-hold by an average of 3.7 percentage points per annum over the 42 years since 1969.

The strategy outperformed again in 2011, staying in cash during the first nine months of the year before switching into equities in time for a fourth quarter rally. It returned 7.6% more than cash for the year versus a 5.3% loss for buy-and-hold.

The three rules currently suggest that 1) the global economy will expand respectably during the first half of 2012, 2) inflation will trough around the middle of the year and move up into 2013 and 3) equities remain attractive relative to cash. See previous posts here and here re 1) and 2).

Investors are better able to exploit a successful forecasting method when it is not widely employed. The monetarist approach, fortunately, remains deeply unfashionable with an economics herd obsessed with short-term data watching and dissecting the pronouncements of clueless policy-makers.

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Reader Comments (2)

Hi Simon -
Would you be able to post the liquidity v. output graph (ann. chg.) as I haven't seen it here recently?
Sometimes you post the 6mth chg. chart but I sense that is not your preferred for your equity/cash allocation model...
Regards and thanks for a consistently useful blog!
Tony B

February 20, 2012 | Unregistered CommenterTony Beckwith

Thanks for raising an important issue. The investment strategy described in the post is based on comparing annual growth rates of G7 real money and output. However, there may be a case for shifting to G7 plus emerging E7 measures to reflect the increasing importance of the latter grouping. The six-month relationship, moreover, will give earlier signals and may be more useful at a time when markets seem particularly sensitive to liquidity shifts. Any thoughts would be welcome. I'll provide a monetary update soon.

February 24, 2012 | Registered CommenterSimon Ward

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