The third “monetarist” forecasting rule followed here is that financial markets usually perform better when the real money supply is growing faster than economic output – this suggests that there is “excess” liquidity available to push up asset prices.
Excess liquidity can buoy all markets or flow into a particular asset class, depending on the stage of the business cycle and other factors. A typical sequencing would be for “safe” bonds to perform strongly around the trough of the cycle followed by equities and lower-grade credit in the recovery phase, with commodities and property taking up the baton as the upswing matures and the economy reaches capacity limits.
A simple stock market investment rule that acknowledges this sequencing is to buy global equities six months after the annual change in G7 real narrow* money growth crosses above that of industrial output and move into cash immediately on a reversal. The six-month entry lag allows for excess liquidity to flow initially into bonds – equities, indeed, often struggle during this window, perhaps reflecting negative earnings news related to economic weakness.
As discussed in previous posts, such a rule would have significantly outperformed a passive investment strategy. Between the start of 1970 and the end of 2011, global equities returned 2.4% per annum more in US dollar terms than US cash. The monetarist investment rule would have delivered 6.1%. The first chart below updates a cumulative excess return comparison.
The investment rule moved to cash in January 2010 but switched back into equities in September 2011, since when global stocks have outperformed by 18% (as of the end of August). The “buy” signal remains in force, with G7 real narrow money up by an annual 9% in July versus an estimated 3% increase in industrial output – second chart.
The current version of the rule, however, fails to take account of the now-significant influence of emerging economies on global growth and liquidity conditions. Emerging E7 real narrow expansion is currently below that of industrial output, implying deficient liquidity and helping to explain recent lacklustre performance of emerging equity markets.
A possible resolution is to reformulate the rule in terms of G7 plus E7 real money and industrial output. Recent signals, in fact, have been identical to the original rule, since G7 liquidity developments have dominated the global aggregate – third chart.
The current positive reading, of course, does not preclude a near-term drawdown but the historical record suggests that, from the September 2011 entry point, equities will have outperformed cash by the time of the next liquidity “sell” signal.
*A narrow money measure is preferred because excess liquidity is likely to be transferred into demand / sight deposits prior to an increase in investment or spending. The historical performance of a rule based on broad money is inferior.
