Wall Street’s Long-Term Wealth Creation
Over long periods, Wall Street has proven to be a formidable engine of wealth creation. Compared to other asset classes such as gold, oil, housing, and Treasury bonds, stocks have significantly outperformed in terms of annualized returns over the past century. This superior performance underscores the stock market’s capacity to generate wealth over the long haul.
Short-Term Market Uncertainty
However, the picture changes when the focus shifts to shorter time frames, such as a few months or a couple of years. The performance of broad-market indexes like the Dow Jones Industrial Average (DJIA), the S&P 500, and the Nasdaq Composite becomes much harder to predict. In the first few years of this decade, these indexes have swung between bear and bull markets, highlighting the inherent volatility of short-term market movements.
Investor Behavior in Volatile Markets
When the stock market is volatile, investors naturally seek out clues to help them predict future trends. Although no indicator can guarantee accurate predictions, some metrics have historically correlated with significant market shifts. One such metric, currently signaling a potential issue, is the U.S. money supply—a situation we haven’t seen since the Great Depression.
The U.S. Money Supply Indicator
The U.S. money supply has five measures, but M1 and M2 are the most relevant. M1 includes cash, coins, and demand deposits in checking accounts—essentially, money that is easily accessible. M2 includes everything in M1 plus savings accounts, money market accounts, and certificates of deposit (CDs) under $100,000. M2 represents money that is accessible but requires a bit more effort to use.
Historically, the M2 money supply has steadily increased, supporting the growing economy. However, recent trends indicate a concerning decline. In April 2022, M2 peaked at $21.722 trillion but had fallen to $20.867 trillion by April 2024—a decrease of nearly $855 billion or 3.94% over two years. This marks the first time since the Great Depression that the M2 money supply has declined by more than 2% from its peak.
Historical Context and Economic Implications
To understand the significance of this decline, we need to look at historical data. Instances where M2 declined by at least 2% year-over-year are rare and have historically coincided with severe economic downturns and high unemployment rates. Notable occurrences were in 1878, 1893, 1921, 1931-1933, and 2023—periods associated with economic depressions.
The Federal Reserve and federal government are now better equipped to handle economic turbulence than in the past, which reduces the likelihood of a severe economic downturn. Nonetheless, the decline in M2 suggests that the U.S. economy may weaken in the near future. With less capital in circulation, consumer spending is likely to decrease, often a precursor to a recession.
The Long-Term Perspective: Time as an Ally
Despite these short-term concerns, the long-term outlook for investors remains positive. Historically, the U.S. economy and stock market have shown resilience. Economic cycles consist of both booms and busts, but expansions typically last longer than recessions. Since World War II, only three of twelve U.S. recessions have lasted 12 months or more, whereas economic expansions often endure for several years, with some lasting up to a decade.
Similarly, on Wall Street, bull markets tend to outlast bear markets. Data from Bespoke Investment Group shows that the average S&P 500 bull market lasts about 1,011 days, compared to 286 days for bear markets. Additionally, there have been 13 S&P 500 bull markets that lasted longer than the longest bear market since the Great Depression.
Further evidence of the benefits of long-term investing comes from Crestmont Research, which analyzed rolling 20-year total returns for the S&P 500 (including dividends) since 1900. They found that every 20-year period produced a positive annualized return. This means that investors who held an S&P 500 index for 20 years always made money, regardless of short-term market fluctuations.
Current Market Dynamics
In the present context, the market’s surge in valuations has been significantly driven by liquidity and the performance of tech stocks, especially those involved in artificial intelligence (AI). Investors are now paying 20.57 times the projected earnings per share (EPS) of the S&P 500 for the next year, marking a 3.4-point increase from the market’s low in October.
Money-market funds, which hit $6 trillion in February 2024, are a major source of this liquidity. Additionally, the Federal Reserve’s overnight reverse repurchase facility—where institutions park excess cash—stands at $440 billion, and the M2 money supply hovers around $21 trillion. This liquidity fuels market valuations and allows investors to take on more risk, particularly in tech stocks.
Tech giants, known as the Magnificent Seven (Nvidia, Apple, Amazon, Microsoft, Alphabet, Tesla, and Meta Platforms), are trading at a P/E ratio of 30.71 times their projected earnings over the next 12 months. This high valuation has significantly inflated the S&P 500’s overall valuation. However, the S&P 500 Equal-weight index, which gives equal importance to each stock, is trading at a more reasonable 16.31 times its next 12 months’ earnings, indicating a normalization in the broader market.
Market Sentiment and Risks
Investor behavior and market momentum also play crucial roles in sustaining high valuations. The stock market’s strong performance, with the S&P 500 closing at record levels 24 times in the first half of the year, creates a sense of exuberance. Investors are reluctant to sell in a rising market, which means buyers must pay increasingly higher prices to attract sellers. This momentum-driven behavior can keep valuations elevated beyond what economic fundamentals might justify.
Despite the market’s bullish sentiment, some experts caution that the current high valuations may not be sustainable. There is concern that the stock market is driven more by sentiment and speculation rather than economic fundamentals. David Rosenberg, referencing economist Alan Greenspan’s concept of “irrational exuberance,” argues that the market’s behavior reflects irrationalism rather than a sound economic backdrop.
If inflation rises too high or if the earnings from tech companies, particularly those involved in AI, do not meet lofty expectations, the market could face a significant correction. This potential for overvaluation and the associated risks means that while the market is currently buoyant, it may be vulnerable to a downturn.
Conclusion
In summary, while current signals such as the decline in M2 money supply suggest potential short-term challenges for the U.S. economy and stock market, the long-term outlook for investors remains positive. Economic expansions and bull markets typically outlast recessions and bear markets, and historical data demonstrates that time is a powerful ally for investors. By maintaining a long-term perspective and disciplined investment approach, investors can navigate short-term volatility and benefit from the stock market’s wealth-creating potential over time.