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The Real Measure of Stock Market Growth: Accounting for the US Dollar Money Supply



When analyzing the growth of the stock market, many investors focus solely on headline stock market indexes like the S&P 500 or Nasdaq Composite. However, these raw index numbers can be misleading and fail to capture the true underlying trends. The real measure of stock market growth that investors should be focused on is the performance of the stock market adjusted for changes in the US dollar money supply. The reason for this is simple - the stock market does not exist in a vacuum. It is heavily influenced by the broader macroeconomic environment, and in particular the monetary policies of the Federal Reserve. When the Fed increases the money supply, this extra liquidity tends to flow into financial assets like stocks, driving up their nominal prices. Conversely, a tightening of monetary policy and a reduction in the money supply can cause stock prices to decline, even if the underlying value of companies has not changed.



To illustrate this, let's look at some historical examples:


  • The Dot-Com Bubble: During the late 1990s, the Fed pursued a very loose monetary policy, dramatically increasing the money supply. This excess liquidity fueled speculation and drove stock prices in the technology sector to unsustainable heights, leading to the Dot-Com Bubble. When the Fed eventually tightened policy in 2000, the bubble burst, and stock prices plummeted even though the underlying economic fundamentals had not changed all that much.

  • The Housing Bubble and Great Recession: In the mid-2000s, the Fed kept interest rates unusually low for an extended period, flooding the economy with cheap credit. This fueled a speculative frenzy in the housing market, leading to the formation of a massive asset bubble. When the bubble inevitably burst in 2008, it triggered the Great Recession - but the initial driver was the Fed's loose monetary policy, not changes in the underlying value of companies.

  • The COVID-19 Pandemic: During the COVID-19 pandemic, the Fed responded by dramatically increasing the money supply to stabilize the economy. This flood of liquidity drove the stock market to new all-time highs, even as the real economy was in recession. An analysis of the stock market adjusted for money supply growth shows that the market's performance was not as impressive as the headline indexes suggested.


These examples illustrate how changes in the money supply can significantly distort the stock market's performance, making it appear stronger or weaker than the underlying economic and corporate fundamentals would suggest. That is why it is essential for investors to look beyond the raw index numbers and consider the impact of monetary policy when assessing the true health and growth of the stock market.


Adjusting for the Money Supply: A More Accurate Measure of Stock Market Growth


To adjust the stock market's performance for changes in the money supply, investors can use a simple formula:


  • Real Stock Market Growth = Nominal Stock Market Growth - Money Supply Growth


This formula allows us to strip out the distorting effects of monetary policy and get to the heart of how the stock market is truly performing based on the underlying economic and business fundamentals. Let's look at a hypothetical example to illustrate how this works in practice:


  • Suppose the S&P 500 index rises by 12% in a given year. On the surface, this might seem like a strong performance. However, during that same period, the broad US money supply (as measured by M2) increased by 8%. Real Stock Market Growth = 12% - 8% = 4%


This tells us that the "real" or underlying growth of the stock market, after accounting for the impact of the expanded money supply, was only 4% - a much more modest figure than the raw 12% increase would suggest. By consistently applying this adjustment for money supply growth, investors can develop a more nuanced and accurate understanding of the stock market's performance over time. This provides crucial context that allows for better investment decisions and portfolio management. It's important to note that the relationship between the money supply and stock prices is not perfectly linear or immediate. There can be lags, as well as other factors that influence market dynamics. But over the long-term, this adjustment for money supply growth has proven to be a reliable way to gauge the true health and growth of the stock market.


The Stock Market's Real Growth Over the Past 20 Years


Applying the framework of adjusting stock market performance for money supply changes, let's take a closer look at how the US stock market has fared over the past two decades. From 2003 to 2022, the S&P 500 index rose from 902 to 3,839 - a nominal increase of over 325%. This seems to indicate a period of tremendous and sustained growth for the stock market. However, when we factor in the dramatic expansion of the US money supply over this time period, the picture looks quite different. The M2 money supply measure, which represents a broad definition of the money available in the economy, grew from $6.8 trillion in 2003 to $21.8 trillion by the end of 2022 - an increase of over 220%. Plugging these numbers into our formula: Real Stock Market Growth = Nominal Growth (325%) - Money Supply Growth (220%) = 105%. This means that the "real" or underlying growth of the US stock market, after accounting for the inflationary effects of money supply expansion, was approximately 105% over the 20-year period from 2003 to 2022. While still a healthy return, this is significantly lower than the 325% nominal gain suggested by the raw S&P 500 index. It paints a more nuanced picture of the stock market's performance, stripping out the distorting impact of the Fed's monetary policies.


Furthermore, the rate of real stock market growth has been uneven over this period. During the relatively stable monetary policy environment from 2003 to 2008, the real growth rate was around 12% per year.

However, in the aftermath of the Global Financial Crisis and the subsequent extraordinary monetary interventions by the Federal Reserve, the real growth rate has been much more muted, averaging only around 4-5% annually from 2009 to 2022. This analysis underscores how crucial it is for investors to look beyond headline stock market indexes and consider the influence of the money supply. By doing so, a more accurate and insightful understanding of the stock market's true underlying performance emerges - one that is essential for making well-informed investment decisions.


While headline stock market indexes provide a useful barometer, they do not tell the whole story. To truly measure the stock market's growth, investors must account for changes in the US dollar money supply. By doing so, they can separate the signal from the noise and make more informed decisions about where to allocate their capital.

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