Predicting what will trigger the next economic crisis and stock market downturn should be difficult. After all, if the trigger was easily identified it would probably already be priced in. Sometimes the trigger might be easier to spot, but the problem still remains as to when it will be pulled.
But since a trigger would not be a trigger if no one acted on it, it is perhaps easier to track how economic actors actually do behave rather than trying to identify the elusive trigger. To cut a longer story short, the onset of a GDP recession and a stock market correction usually involves a decline in the money supply growth rate and an increase in personal saving relative to spending. The two represent the supply of money and the demand for money. Of these two, saving relative to spending is the more important over the shorter term since it can change substantially quicker and more dramatically than the money supply.
The relationship between the money supply and personal saving relative to spending is a proxy for what Ludwig von Mises referred to as the money relation; the relation between the demand for money and the supply of money. 1 Money becomes more "abundant" (liquidity increases) whenever the money supply growth rate accelerates and saving relative to spending declines. Conversely, money becomes more "scarce" (liquidity decreases) when the money supply growth rate contracts and people decide to save more (i.e. spend less). Increased liquidity is positive for stocks while decreased liquidity is a negative.
A simple but effective economic indicator can thus be constructed by comparing changes in this money relation over time. 2
As the chart shows, the money relation signaled a significant tightening in liquidity for some time prior to the dotcom and telecom crises in the early 2000s and the 2008 banking crisis. As is also apparent, the money relation has been remarkable stable and mostly positive for the last two years. It has also climbed in recent months which may help explain why stocks have performed well following the election of Trump. Though the money supply growth rate jumped in September, October, and November last year, it is especially a decline in saving relative to spending that in recent months has pushed the indicator to levels last seen in 2013.
Recessions and financial crisis never appear out of nothing; they are the results of economic imbalances that have built up over time. These imbalances are created as a direct result of monetary expansion and inadequate saving; that is, readings above zero in the chart above. The higher the readings and the longer they last, the bigger the potential economic imbalances and the correction that must follow. The above chart and the theory underpinning it is therefore founded on the Austrian theory of the business cycle.
In due course, the economic imbalances reveal themselves in steep declines and recurring readings way below zero in the money relation. For example, the money relation signaled problems more or less consistently in the months leading up to the 2001 and 2008 recessions and stock market crashes. Especially 2008 is a case in point when the money relation first started dropping in January for then hit a record low of -183% in May. This was followed by three consecutive months of readings below -50% before Lehman collapsed in September and a full-fledged banking crisis broke out. The money relation then tanked further.
The point is that this indicator has historically provided ample and often solid warnings before a crisis broke out. Perhaps even more importantly, though there have been a few false warnings along the way (e.g. mid 1990s), there has never been a recession or a stock market correction based on data since 1988 without the money relation first turning negative. This is depicted in the chart below where the money relation (smoothed over five months) is compared with the year on year percentage change in the U.S. stock market (shown with one month lead). The dotted red boxes represent U.S. recessions.
The current reading of the money relation therefore suggests liquidity is ample and that the coming U.S. financial crisis is not imminent. That does not mean however that the stock market cannot fall as stocks can decline without a recession setting in; valuations also do play a role. With valuations this high, there is also the risk that a stock market correction could itself be the trigger - crashing stock prices affect economic developments as they so utterly destroy the "foundation" an elastic money supply and fractional reserve banking is built on; confidence.
But things can change quickly, and the stable and slightly positive readings in recent months could very well be the calm before the storm. Neither continued increases in the growth rate of the supply of money nor a reduction in saving relative to spending is possible over extended periods without disruptions. Bank lending growth has fallen sharply recently which acts to reduce the growth of the supply of money. If the supply of money becomes less abundant, this could very lead to consumers tightening their belts favoring increased saving over further increases in spending. The money relation will turn into negative territory as a result. When this happens, watch out.
1 See the book Human Action. Just like any other good, the price of money is influenced and determined by the subjective valuations of actors as reflected in supply and demand. The relation between the demand for money and the supply of money determines the purchasing power of a currency. As there is a direct inverse relationship between the purchasing power of money and prices of goods and services, a decrease in money supply and increase in savings compared to spending will bring about a decrease in prices and an increase in purchasing power (all other things unchanged). Conversely, an increase in money supply and decrease in savings compared to spending is price inflationary, i.e. leading to reduced purchasing power. The money relation therefore affects the exchange ratio between money and goods (i.e. it is a determinant of the purchasing power of money and money prices) in a similar manner to what the quantity of goods and services produced does. I deal with this subject in detail in the book Money Cycles.
2 The supply of money is calculated as the y/y growth rate of the money supply and the demand for money is calculated as the y/y growth rate in personal saving divided by personal consumption expenditures. The growth rate in saving/consumption ratio is then subtracted from the growth rate of the money supply. The percentage point change in the resulting number from one year ago then represents the change in the money relation for that month.
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