Topic #6 – Little relationship between annual changes in US M2 Money Supply and S&P 500 over past 20 years

The US M2 Money Supply is down 0.88% over the past year, a rare decline given that it has been rising annually for the past 20 years. M2 is defined as an aggregate of cash, demand and checking deposits, savings and time deposits, certificate of depositis, money market funds and government bonds held by individuals. This report looks at the relationship between annual changes in US M2 Money Supply and S&P 500 over the past 2 decades, representing 2 economic cycles, to find out the impact of a shrinking money supply for investors going forward.

From the table (Figure 1), we can infer there is generally a positive relationship between annual changes in US M2 Money Supply and S&P 500. In the 19 instances when M2 rose year-on-year, the S&P 500 recorded a gain in the corresponding year 15 times (78.9%). The average annual change in M2 was 6.87% while that of S&P 500 was 9.11%.

However when studying the corresponding extent of annual changes in M2 and S&P 500 (Figure 2), the strength of the relationship between these 2 variables appeared to be weak. The correlation coefficient, a statistical measure of the strength of a linear relationship between 2 variables, was only 0.15 which suggested a weak positive correlation between the percentage change in M2 and S&P 500 annually.

When calculating the coefficient of determination (also more commonly known as r-squared), which determined the proportion of variance in the dependent variable that could be explained by the independent variable, the value was only 0.02 for M2 and S&P 500. This meant that the annual change in M2 was only able to predict just 0.2% of the variation in S&P 500’s return over the year.

Conclusion:

While there was generally a positive correlation between annual changes in M2 and S&P 500 over the past 2 decades, the strength of the relationship between them was weak and could not be used effectively to sufficiently determine the extent of change in S&P 500 by inferring from the change in M2 for a given year. This year the S&P 500 is up over 16% year-to-date while M2 has declined 1.89% year-to-date by US$400B from US$21.2T in January. So, investors should also pay attention to many other variables such as GDP, unemployment rate, consumer confidence etc. which also influence the performance of S&P 500.