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.