BT: Money supply and stock returns revisited

Business Times - 29 Oct 2005


Money supply and stock returns revisited

An analysis of data from the last 15 years or so shows that an increasing rise in M1 growth means good news for the local stock market

By TEH HOOI LING
SENIOR CORRESPONDENT

'IN the stock market, as with horse racing, money makes the mare go,' observed Martin Zweig in his book Winning on Wall Street. 'Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate - primarily the trend in interest rates and Federal Reserve policy - is the dominant factor in determining the stock market's major direction.'

This is why every time there is a US Federal Open Market Committee meeting, the market will try to work out in advance if it will increase or decrease the interest rate. And if the increase is higher than anticipated, the stock market will fall.

Monetary policies can be classified broadly into three types: expansionary, neutral, or restrictive.

The central bank or monetary authority is said to take an expansionary monetary policy stance when it acts to increase the level of reserves in the banking system. Its objective in doing so is to achieve a higher growth rate of money supply to stimulate economic activity or to sustain a current level of economic activity that it believes is non-inflationary.

Conversely, the central bank is said to take a restrictive stance on monetary policy when it acts to decrease the level of reserves in the banking system. In such a case, the central bank's objective is to lower economic activity in order to curb inflation.

Finally, the central bank can take a neutral stance and attempt to hold the level of reserves relatively constant.

Central bank operations

Whether the central bank is pursuing an expansionary or a restrictive monetary policy at a given point in time can be determined by the money supply in the economy, interest rates, bank reserves and the central bank's open-market operations, that is, buying or selling government securities in the open market.

Last year, in this column, I tried to link the movement in money supply with that of the stock market. A reader wrote in this week requesting that I update the figures.

As mentioned before, the figures for the various measurements of money supply can be found at the Monetary Authority of Singapore website (www.mas.gov.sg).

Narrow money supply, or M1, includes currency and on-demand deposits. And the M1 money supply plus timed deposits is referred to as the M2 money supply.

There is a lag of about two months in the figures put out by the MAS. For example, we are now coming to the end of October but the latest figures found at the website are those relating to August.

I have decided to test whether two-month old data are of any use in predicting the stock market movement. I took the year-on-year growth in M1 and matched it to a stock market price index two months later. For example, I found the growth in M1 between January 1991 and January 1992 and matched that to the SES All Shares Index, the Straits Times Index and the UOB Sesdaq on April 1, 1992.

The M1 growth from February 1991 to February 1992 were matched to the indices for May 1, 1992, and so on. I then plotted the series on three graphs.

The results, as you can see, show that there is a surprisingly close co-movement between the two-month lagging M1 growth and that of the stock market indices.

The correlation between the SES All Shares Index and the two-month lagging M1 growth is 0.55. (A correlation of one between two sets of data means that they move in perfect lock-step, that is, a 10 per cent increase in set A is accompanied by a 10 per cent increase in set B. A correlation of zero means there is no link whatsoever between the two sets of data.)

Meanwhile, the M1 growth matched to the one-year return of SES All Shares Index also yielded a correlation of 0.55.

The correlation between the two-month lagging M1 growth and the STI is 0.41. But when compared with the one-year return of the STI, the correlation is a strong 0.58. For UOB Sesdaq Index, it is 0.49 and 0.41 respectively.

In other words, in the last 15 years or so, on most occasions, an increasing rise in M1 growth means good news for the stock market. For example, if the year-on-year M1 growth was 8 per cent in March, 12 per cent in April and 15 per cent in May, things bode well for the market.

However, if the growth was 18 per cent in March, 14 per cent in April and 8 per cent in May - even though there is growth, but at a decreasing rate - that's a sign that perhaps stock market prices are on their way down. You can see the pattern clearly on the charts.

And even though the MAS data are two months late, they are very timely indicators.

So where is the M1 growth going now? As can be seen from the charts, they have been chalking up a decreasing growth rate. And that's not a good sign for the stock market. And indeed, market indices have been in correction in the last few weeks.

Given that the interbank rates are rising, chances are the growth in M1 will continue to be in a downward trend. So beware.

Meanwhile, numerous studies have been done in the US on the Fed policy on stock returns. In a recent study, Conover, Jensen, Johnson and Mercer concluded that:


First, monetary conditions have had and continue to have a strong relationship with security returns. In particular, periods of expansive monetary policy are associated with strong stock performance (higher-than-average returns and lower-than-average risk), whereas periods of restrictive monetary policy generally coincide with weak stock performance.


Second, a highly consistent relationship between monetary conditions and stock returns is evident over time.


Third, small cap companies are more sensitive than large cap companies to changes in monetary conditions. Portfolios of small cap stocks have economically and statistically significant monetary policy-related return patterns that are consistent over time.


Fourth, cyclical stocks have a much higher sensitivity to changes in monetary conditions than defensive stocks. For example, stocks in the cyclical consumer goods, cyclical financial services and information technology sectors had expansive-period returns that were more than 26 percentage points higher a year than the returns they earned during restrictive periods.


Finally, US monetary policy has an important influence on global markets. They found significant return patterns related to US monetary policy for five international indices, including Asia. This evidence is consistent with the prominent role US economic conditions play in the prospects of foreign companies.

'Overall, our evidence strongly suggests that practitioners should devote considerable attention to monetary conditions as part of a thorough economic analysis,' they concluded.

'Furthermore, because sensitivity to changes in monetary conditions deviates considerably among sectors, a rigorous industry analysis is also essential. Finally, investment professionals who are attempting a sector or industry rotation strategy should carefully monitor changes in Fed monetary policy,' they added.

The writer is a CFA charterholder. Her e-mail: hooiling@sph.com.sg

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