The stock market is running on fumes. More than a hunch, this is a calculated assessment based on concrete numbers in money supply growth. When "bull markets" are being fueled by quantitative easing, and we all know this one is and has been for a while, then all you have to do to figure out when it's going to end is keep your eye on the money supply figures. This is different from the monetary base itself. Most investors know that the Federal Reserve is increasing the monetary base by $85B a month in mortgage backed security and bond buying, a number repeated all the time in the media since QEternity was announced. But the more important and less reported number is the amount of that money entering circulation as opposed to staying in reserves, which is actual money supply growth. This number depends on banks' willingness to invest that money or lend it out rather than park it back at the Fed.
Calculating these numbers is a bit tedious but it can be done. It involves wading through a sea of Federal Reserve Data and computing it. Here's how. If you go to the Federal Reserve's H.6 release on money supply growth, trek over to the second table to the 13-week non-seasonally adjusted M2 column, what you'll find is that the annualized M2 growth from April 25 reaching back to January 21 is only 3.8%. You take the number released on April 25 (10490.9), divide by the first number (10391.8), subtract 1 to get the pure percent change and then multiply by 4 to annualize. The number 3.8% isn't scary on its own, but being that growth is down from a peak of 11.4% 12 weeks before, shrinking every single week down to 3.8% is what is alarming. Last week's growth number from the May 3 release has ticked up to 3.9% and this week's to 4.1%, but the trend is still sharply down.
A much clearer picture of what has been going on since December can be seen in this chart:
(click to enlarge)
What you see here is total monetary base versus excess reserves non-seasonally adjusted (NSA). One thing to notice is that since December, the proportion of excess reserves to total monetary base has gone up from 55% in December to 59% in April. (Divide the excess column by the monetary base column.) That means proportionally more new money is being parked at the Fed rather than being circulated every month. But the starkest column is the last one, which is total borrowings from excess reserves, or the amount of excess reserves actually being circulated every month. It has dropped like a rock, only going up by the tiniest fraction in April by an infinitesimal $6M taking into account the entire U.S. banking system. QE isn't working, not merely in the sense that it isn't improving the economy, but in the more basic mechanical sense: the money just isn't moving.
For investors, that means it's not moving into the stock market either. If that trend doesn't reverse fast, then this cyclical bull is over. Within a month, 13-week averaged quarterly money supply growth could slip under 3% annualized, at which point the money supply cannot grow fast enough to feed inflated asset prices, so even if M2 growth does pick up after a dip below 3%, it will shorten the crash, but it won't stop it.
The implications for this are as follows. First of all, as monetary policy stands now, it doesn't matter how much the Fed increases the monetary base. None of it will circulate if banks do not want to use or lend that money. So an increase of QE from the current $85B a month to $100B a month or even more won't change the M2 money supply growth picture. Therefore, QE by itself can no longer levitate the markets, and traders should buy the rumor and sell the news of any increase in quantitative easing. It's a red herring.
What should be bought, and bought aggressively, is any news of the Fed lowering or eliminating the interest that it pays banks to park excess reserves. Or better yet, any news that the Fed will actually charge banks to park money, thereby almost forcing them to lend it out or invest it. However, I don't see this happening before a crash forces it because the amount of excess reserves parked at the Fed is so colossal that to charge banks to keep money there would be exceedingly dangerous. You can't have $1.8 trillion dollars suddenly flood the system in a torrent. That would be too much even for Paul Krugman. Below is the St. Louis Fed's graph of excess reserves.
Below is a zoom in I created using the Excel data of excess reserves from the moment they started to explode in September 2008.
Now take a moment to look at the data at this link. These are the H.6 money supply numbers for that same fateful month of September 2008 when the Fed began seriously increasing the monetary base in response to the financial crisis. If we do the same exact calculation we did above, namely go to the second table, divide the August 25 13-week M2 NSA average by the June 2 number, we get 7700.8/7703.5. Subtract 1, multiply by 4 to annualize = negative .14%. The money supply was actually shrinking despite the massive money pumping. It just wasn't being moved out of excess reserves fast enough. In an economy based on inflation, that means crash. And that is precisely what happened.
Those numbers were published on September 4, 2008. On that day the S&P was at 1242, having been going steadily down due to declining money supply growth already, but never averaged negative. By September 19, only 2 weeks after those numbers came out, the crash had already begun. By October 2 our number finally went back into positive territory, but by October 10, the S&P had plummeted to 900 and money supply growth was only back up to an anemic 2.9%, still very low and below the crucial 3% mark. That meant there was still more downside to go. By market bottom in March 2009, the Fed finally got the M2 growth numbers high enough, and the key number was up to an amazing 16%. (Just follow the same calculations as before to see for yourself.) At that point, confirming heavy money supply growth averages in the double digits in January and February, it was time to buy.
What this shows is that it takes about 3 months for money supply numbers to affect the markets on the upside. This is about how much time it takes for new money to circulate and get to the stock market. On the downside however, if the number is negative, a crash is only a week or two away. So watch that number carefully. Right now it's at 4.1% and has ticked higher for 2 straight weeks from a bottom of 3.8%.
What will happen from here? It all depends on where that number goes, but here's one guess. The Fed does not have the political clout to start charging banks to keep money in reserve, and it's simply too dangerous to do so. Talk about running through a dynamite factory with your hair on fire. Therefore, the 13-week annualized average may keep shrinking as it has been doing since January when the number came in at 11.4%, to below 3% in about a few weeks, and perhaps even to negative in 2 to 3 months. When the number breaches 3%, start liquidating. If it goes below 2%, you should be 100% cash. If it goes negative for even one week, take a small position in out of the money puts on the SPY S&P 500 ETF and a larger long position in the dollar ETF UUP, which will spike in the event of a crash but still has low volatility. If our number stays negative for two weeks, you may even consider a small position in leveraged bear funds like SPXU or exotic VIX funds like UVXY or TVIX to be held for 2 to 3 weeks only, but only if that key number stays negative for 2 weeks. Never hold a VIX fund for longer than that, and never more than a 5% position.
The way back up will be just as interesting. After a crash, the Fed will have the political clout to do what it wants. Expect the Fed to double down on QE and cut or even eliminate the interest it pays banks on excess reserves. In that case, the biggest beneficiaries of the new inflation will be gold (GLD) and gold miners (GDX), as price inflation will be set on fire as reserves flood the system and miners are perhaps the most undervalued sector on Wall Street.
Another steady climb, however, depends on the Fed's ability to control the amount and rate of money coming out of excess reserves. If it comes out too slowly, as is happening now, it causes a crash. If it comes out too fast, it causes price inflation. And with $1.8 trillion currently in excess reserves out of a total $3 trillion monetary base, that price inflation could be quite heavy indeed.
Of course, banks could decide to lend faster starting now, in which case the crash could still be aborted. In any case, it's the money supply growth number that has the best predictive value, whichever way it ends up going. We'll see what happens in the next several weeks.