Previous posts (e.g. here) have discussed a “monetarist” investment strategy involving holding either global equities or US dollar cash depending on whether annual growth of G7 real narrow money is above or below that of industrial output*. The rationale for the strategy is that faster expansion of real money than output may signal that liquidity supply has run ahead of demand – such an excess may prompt additional buying of equities and other assets.
Slower growth of real money than output, by contrast, may indicate that liquidity supply is insufficient to support current economic activity – individuals and firms may then sell assets in an attempt to raise cash, pushing down prices.
The strategy performs well in an historical backtest: the excess return compared with buying and holding equities averaged 3.6% per annum over 1970-2012 – see first chart. These results are based on currently-available data but annual real money and industrial output growth could have been calculated in real time and subsequent data revisions would probably have made little difference to the timing of cross-over signals.
The last “buy” signal for equities occurred at end-September 2011, since when global stocks have outperformed cash by 40%.
The gap between the annual growth rates of G7 real narrow money and output remains large but has narrowed recently, reflecting both stronger economic activity and slower monetary expansion – second chart.
The still-wide gap, moreover, is mostly due to developments in late 2012 / early 2013: output has grown by only slightly less than real money in the latest six months – third chart.
The current pick-up in the global economy suggests that the six-month increases will cross by the autumn, barring unexpected monetary reacceleration. This, in turn, could presage convergence of annual growth rates around end-2013.
The monetarist approach, in other words, is still giving a positive message for equity markets currently but suggests that conditions will become less favourable in 2014.
*A six-month lag is applied before buying equities after a positive cross-over.
