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Markets rise and fall based on money flow. If money is coming into an asset class at a faster pace than it is leaving, over a long period of time, returns for that asset are going to positive relative to others. While GDP is the most frequently cited economic measure in predicting the net money flow of the market, there are some data series that would suggest a much bleaker picture of projected money flows into equities in the upcoming months and years. (Click charts to enlarge.)

First, M1 money supply. As you can see from the chart above, there has been a recent upward spike in this measure. M1 is, for lack of a better phrasing, the amount of liquid cash available to consumers. The significance of this recent rise could be explained effectively mainly by any combination of three factors. Either banks started lending more aggressively, people are earning considerably more, or people are liquidating non-liquid assets.

To debunk the notion that banks may be lending more aggressively, leading to the extra liquidity in the system, all you must do is check the most recent consumer credit report. As you can see from the table below, consumer credit in the months of July and August actually contracted. So this means that the recent increase in liquidity isn't due to more lending. While some of the decreases witnessed in July and August may be attributable to customers paying down loans, it is clear from the data that credit is still far off of its per GDP highs and does not explain the surge in M1.

Unemployment and underemployment also remain high. Without dwelling on the issue too much, I seriously doubt the meteoric rise of M1 can be explained by improvements in the labor market. While it is possible that pay distributions have changed to an extent, these would be gradual changes that wouldn't manifest themselves as spikes in the chart.But rather as gradual trends in the data series.

This leads to the conclusion that retail investors have been pulling money out of the market at a virtually unprecedented rate. Now, the major caveat remaining in the analysis is how impactful should this size of liquidation be? After all, as it stands today, the total M1 is only ~$2 Trillion compared to a world market cap of all traded companies of ~$50 Trillion. Could this small piece of the pie actually make a meaningful impact?

I believe that the answer may be yes, consider the reasoning. The inflows and outflows of money are going to dictate the long term direction of the market, and if you are a hedge fund and allowed to use a multitude of both long and short speculative instruments, it is simply good game strategy to allocate your clients' assets (what also could be considered inflow) in the direction of the non-fast-money flows. These non-fast money flows can include corporate buybacks, mergers and acquisitions, or (in this example) retail investors. Growth-static hedge fund money playing exclusively against other growth-static hedge fund money is zero-sum, where in the past, net inflows have made the game worth playing on the long side the is no rule of nature necessitating that this will continue. What would happen if the perception of stocks as the "best investment" were to change? The most nimble funds would adjust their strategy accordingly, and participate in the direction of net money flows - everyone wants to play a sum-positive game if they can. Obviously this scenario would imply a very volatile sell-off, probably testing or maybe even eclipsing the lows of March 2009.

GDP is used so commonly by market pundits to forecast market direction because it is generally believed to be a proxy for income. While the positive Q3 reading of 2.5% annual growth gives reason for optimism, there are also bearish conclusions to be drawn when analyzed in conjunction with money supply data. The GDP growth was largely driven by an increase in personal consumption expenditures, in this regard, it was the increase in liquid money supply rather than its velocity that helped contribute to the growth.

Notice that the velocity of money continues to decrease, so the PCE gains are more attributable to the liquidated asset base rather than the rate of spending - this is untenable - money was liquidated from the market, money that if re-allocated wouldn't be spent, and thus no longer contributing to PCE growth. Now, money re-allocated would contributed to the private investment component of GDP, but considering M1 velocity is still at ~7X, the impact of the growth of the liquid cash base still easily outpaces the impact of investment in the context of the GDP measurement.

At the end of the day, economic growth is just a proxy for money flows. Money flow into the market and GDP growth are not exactly the same. In fact, as shown in this example, they are interconnected and sometimes even cannibalistic. Understanding and interpreting money flow is imperative to predicting the direction of any market. Keep an eye on these indicators.

Source: M1, Q3 GDP, And Interpreting Money Flows