The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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January 21, 2006

Money And The Stock Market

In my previous post I highlighted an article from MarketWatch that included this conclusion:

... changes in M1, M2 and M3 are "next to useless" as [stock] market timing indicators.

Spencer England (of Spencer England's Equity Review) says not so fast, and sends me this graph of the S&P price-to-earnings ratio and the growth rate of real money balances measured, by Zero Maturity Money (MZM):

OK -- I'm impressed, but I'm not sure what to make of it.  The savvy folk rush to liquidity when the P/E ratio moves north?  Spurious correlation (because both series are positively related to the overall level of economic activity)?  Any suggestions?

January 21, 2006 in Federal Reserve and Monetary Policy | Permalink


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I would say it is spurious. Kind of akin to trying to correlate different kinds of baseball statistics. How do you explain the sideways trade in stocks since 2004, with the huge build up in cash in mutual funds? Just because it looks like a duck doesn't mean its a duck in this case.

Posted by: jeff | January 21, 2006 at 07:39 PM

I don't get it. Is it saying that the MZM/PCE can be infinity when PCE is zero? Huh?

Posted by: nobody | January 21, 2006 at 11:20 PM

Money And The Stock Market: Interesting post. But ... While it seems that there is a correlation between the S&P price-to-earnings ratio and the growth rate of real money balances measured, this doesn't tellmuch about the direction of the market. The P/E ratio is a (by definition) a ratio and can move up or down because of increases/decreases in the numberator, the price or increases/decreases in the denominator, earnings. For example, in most recent history, the P/E ratio of the S&P-500 has been trending down, while the index itself has been moving up.

Posted by: SamK | January 22, 2006 at 02:12 PM

nobody -- The basic answer to your question is yes: If the price level is very small, real money balances will be very large. This actually makes perfect sense. The price level -- here measured by the PCE index -- is the number of units of the market basket that you can purchase with $1. So the nominal stock of money divided by the price level is the purchasing power of money. If P is very small, that purchasing power is quite large.

SamK -- Good point. But in Spencer's defense, my understanding is that in the past adjustments in the P/E ratio have been dominated by changes in P. If I am wrong about that, I'm sure someone will tell me.

Posted by: Dave Altig | January 22, 2006 at 10:48 PM

How about this: Later in a business cycle, as the money supply is being tightened, excess liquidity gets used in other things besides working to expand P/E multiples. When earnings are bad but money supply is on the rise, that excess liquidity becomes risk seeking and gravitates to equity investment. I'm sure there is a fairly large behavioral element to this chart that would be hard to quantify, but doesn't take away from the chart's helpfulness.

Posted by: John Bott | January 23, 2006 at 08:15 AM

While everyone talks about the strong correlation between the stock market and earnings you never hear that the correlation between the change in the stock market and the change in earnings is essentially zero. Even if you have perfect knowledge of the future change in earnings it is of no help in telling you what the market will do.

On the other hand the correlation between the change in the market PE and the change in the market is about 0.9. so if you can correctly forecast the direction of change in the market PE you have about a 90% probability of being right on the direction of the market.

On average, since WW II in bear markets the PE falls about one third while earnings actually rise. In the first year of a new bull market this reverses as the PE rises by about a third and earnings actually fall by a small ammount.

Posted by: spencer | January 23, 2006 at 10:42 AM

jeff -- no I am just defining how I calculate real mzm by using the PCE deflator rather then the CPI or PPI.

Also the recent sideways market has been the product of strongly rising earings and falling PEs -- they have been in rough balance

john bott -- you are very much on the right track

Posted by: spencer | January 23, 2006 at 10:48 AM

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