On Friday February 9, 2018, the Dow Jones Industrial Average closed at 24,190.9 a decline of 1,958.49 points from the end of January 2018 or a decline of 7.5%. The S&P500 fell during this period from 2,823.81 to 2,619.55 – a decline of 7.2%.
Most commentators are trying to assure stock market participants that this correction is normal by drawing attention to the prolonged uptrend in the Dow and the S&P500. Thus, both the Dow and the S&P500 were in an uptrend since February 2009 when the Dow closed at 7,062.93 while the S&P500 closed at 735.09.
Since February 2009, the Dow has increased by 270.2% whilst the S&P500 has climbed by 284.1% as at the end of January. Moreover, many experts are drawing people’s attention to the fact that US economic fundamentals are in great shape. For instance, economic activity in terms of real GDP displays strong performance. In Q4 the annual rate stood at 2.5% against 2.3% in Q3 and 1.8% in Q4 2016.
An important reason for the correction, it is argued, is a growing likelihood for the strengthening in price inflation as a result of strong US economic fundamentals. We find this extraordinary, since an expansion in the pool of real wealth should be a mitigating factor for price inflation.
Note that after closing at minus 0.2% in April 2015 the growth momentum of the CPI has been in an uptrend with the yearly growth rate closing at 2.1% by December last year.
To moderate the future strengthening in the growth momentum of the CPI it is expected that the US central bank, the Fed, is going to tighten its interest rate stance.
This, it is held, will lift the entire interest rate structure in particular the yields on the long-term Treasury Bonds. This is seen as major negative for the stock market.
At the end of January, the yield on the 10-year T-Note closed at 2.72% against 2.411% in December last year.
The key for stock market fluctuations is monetary liquidity, which we define as the difference between the annual rate of the money supply and the annual rate of the demand for money. (The proxy for the demand for money in our modelling is depicted by the growth rate of nominal economic activity).
There is an average time lag of 20 months between changes in monetary liquidity and its effect on the annual rate of the S&P500 and the Dow Jones Industrial Average (see chart). Based on this, it is likely that the growth momentum of stock price indexes is likely to come under further pressure in the months ahead.
Contrary to the popular way of thinking, economic fundamentals are not about the growth rate in the demand for goods and services as depicted by the growth rate of GDP but by the economy’s ability to generate real wealth. We suggest that a major negative for the wealth formation process is increases in money supply.
We are of the view that the massive monetary pumping since the onset of financial de-regulation in the early 1980’s has likely severely damaged the US economy’s ability to generate real wealth. On this the money supply to its trend ratio i.e. the AMS to its trend ratio stood at 2.143 in December last year against almost 1 at the end of 1979. In other words, the amount of money has more than doubled in relation to its trend at the end of last year. Having said that the massive pumping has damaged the pool of real wealth, we do not have information regarding the state of the pool i.e. whether the pool is growing, stagnant or shrinking. We cannot ascertain the state of the pool of real wealth because we cannot quantitatively add various goods in the economy (how does one add 1 car and a loaf of bread?).
The severity of the downturn hinges on the state of the pool of real wealth. If the pool of real wealth is stagnant or even worse, declining then the economy is likely to fall into a severe recession.Now, based on the lagged growth momentum of AMS adjusted for price inflation i.e. real AMS it is likely that the growth momentum of industrial production is likely to come visibly under pressure in the months to come (see chart).
With respect to the growth momentum of price inflation we suggest that using the lagged growth momentum of AMS the yearly growth rate of the CPI is likely to strengthen for at least until the end of this year before commencing a visible decline (see chart).
Note that the future trend in the growth momentum of excess AMS is going to be decisive for the turnaround in stock price indexes and the Treasury bond market. Our modelling raises the likelihood that the growth momentum of excess AMS will start gradually strengthening after September this year.
If this were to eventuate then it is possible that the growth momentum of the Dow and the S&P500 could remain under pressure until early 2020 (see chart).Using this forecast of excess AMS growth we can also suggest that the yields on the 10-year T-Bond is likely to remain under upward pressure until year-end before a visible decline is forecast to ensue (see chart).
