Previous posts, e.g. here, have discussed a simple investment strategy involving buying global equities six months after G7 annual real narrow money growth crosses above industrial output expansion and moving into cash immediately on a reversal. This strategy has outperformed buying-and-holding equities by 3.6% per annum since 1970 – see chart. World stocks have beaten cash by 31% since the last “buy” signal in September 2011.

The monetarist “theory” underlying the strategy is that deviations between the supply of money and the demand to hold it are a key driver of asset price changes. If the (unobservable) demand to hold money is assumed to grow in line with the product of industrial output and prices – a reasonable working hypothesis – then the gap between real money and output growth will measure “excess” or “deficient” liquidity.

The historical success of the investment strategy reflects a strong tendency for bear markets to occur during periods of deficient liquidity, i.e. when G7 real money growth falls short of industrial output expansion. This shortfall, in effect, causes firms and households to attempt to raise cash in asset markets, with the resulting imbalance of supply and demand putting downward pressure on prices.

The strategy applies a six-month lag on entry to reflect a tendency for increased liquidity to flow initially into bonds. Indeed, liquidity improvement often begins when the economy is weak and equities still under downward pressure.

The strategy remains invested in equities currently, reflecting a still-wide divergence between the annual rates of change of G7 real money and industrial output – 7.7% and -0.8% respectively in December. The gap, however, may close during the first half of 2013 as industrial activity revives and an energy-led rebound in inflation slows real money expansion.

The rising weight of emerging economies suggests that the rule should now be applied to G7 plus E7 data. G7 plus E7 real narrow money grew by an annual 6.1% in December versus a 0.9% gain in industrial output. The gap, in other words, is smaller than for the G7 but still significantly positive.

Current excess liquidity does not preclude a near-term drawdown nor guarantee that the next “sell” signal will occur at a higher level of prices than today. It does, however, cast doubt on claims that another equity bear market is imminent.