Recent stock market weakness was signalled by a rise in G7 annual industrial output growth above real narrow money, M1, expansion in February. Since 1969, world equities have underperformed US dollar cash by 5% per annum on average when output has grown more strongly than real M1, while outperforming by 11% pa when there has been "excess" money – see charts and earlier post for more discussion.

Between the end of March, when the February output / real money growth cross-over was known, and the end of June, equities underperformed cash by 13% (not annualised).

Based on partial data, G7 industrial output growth was an annual 10% in May versus a 5% increase in real M1. Equities may struggle to mount a sustained rally until this gap closes.

G7 output momentum has been expected to slow during the second half, based on monetary trends and history. This prospect has been confirmed by recent softer business surveys. A "soft landing" scenario might involve annual industrial growth moving down to below 5% by year-end.

If annual real M1 expansion were to stabilise at 5%, therefore, the money / output relationship could generate another "buy" signal in late 2010.

A "double dip", of course, would hasten a new cross-over of industrial growth beneath real money expansion. In this scenario, however, "excess" money would probably flow into high-grade bonds and other "safe havens" rather than equities, which would suffer from earnings weakness. (A temporary slowdown rather than a double dip will remain the central case here unless real M1 contracts.)