Global monetary developments are signalling a prospective slowdown in economic growth and less favourable liquidity conditions for markets. The recovery in the Dow Industrials index since March 2009 continues to display a remarkable resemblance to the rally following the 1906-07 "bankers' panic" bear market, a comparison also suggesting a need for caution.
Six-month growth of G7 real narrow money has slowed progressively from a peak in July, reaching an 11-month low in February – see first chart. The money supply usually leads economic activity by between six months and a year. The last trough in six-month real money growth in January 2010 preceded a low in six-month industrial output expansion 10 months later, in November. Assuming the same lead-time from the recent peak, industrial output should begin to slow from April. Business surveys should soon start to signal this shift.
In addition to the money supply leading economic activity, the gap between real money growth and industrial output expansion is a gauge of "excess" liquidity available to flow into markets and push up prices. Global equities, on average, have underperformed cash when real narrow money has risen more slowly than industrial output. Six-month real money growth crossed beneath output expansion in December, with the gap since widening.
Previous posts have compared the recovery in the Dow Industrials index since March 2009 with an average of rises following six prior bear markets when equities fell by about 50%. The Dow stood 6% above this "six-bear average" at Friday's close while the average falls by 8% by the end of 2011 – second chart.
As discussed in a post in June last year, the recovery in the Dow since March 2009 bears the strongest resemblance to the rebound after the January 1906-November 1907 decline. Like the 2007-09 fall, the 1906-07 bear market was associated with a credit bust and financial panic. Both crises climaxed with the failure of a major institution – the Knickerbocker Trust Company in October 1907, Lehman Brothers in September 2008 – and a subsequent decisive rescue effort (co-ordinated by J P Morgan in 1907, before the institution of the Federal Reserve).
The 20% plus rise in the Dow suggested in the June 2010 post on the basis of this comparison has now occurred. US stocks entered another bear phase at the corresponding stage of the post-1907 recovery. A repeat performance would involve an imminent 14% correction in the Dow and a 20% fall by year-end – second chart.
Weakness on this scale is unlikely barring a major shock but less bullish economic news, slower growth in real money than output and the approaching end of QE2 suggest that equities and other risk assets face increasing headwinds.
