Money supply-driven excess liquidity unveils 20% S&P 500 downside blog

Dear True Insights blog readers. We provide you full access to our latest research note, focusing on Money Supply growth as a tool to estimate (excess) liquidity. It will give you a good understanding of how we aim to use closely-watched macro indicators to derive actionable asset class views and investment ideas. There is a lot of (macro) storytelling related to money supply, but we show that it can be easily transformed into a liquidity measure providing insightful information on current stock market valuation. We trust it will help you make better-informed investment decisions. And if you like what you see, consider becoming a paid subscriber and get articles like this and much more straight in your inbox.


As mentioned in our Weekly Market Monitor, US money supply has been shrinking at an unprecedented rate. Year-on-year, M2 broad money supply has dropped by 4.1%. The 6-month annualized rate of decline is a whopping 6.5%. And while we appreciate the money supply stock vs. flow discussion, it is flow that matters most.

Money Supply vs. Inflation

Money supply growth is almost instantly linked to inflation, the flow in consumer prices. And even though the relationship between the two is far from perfect – contrary to what many investors believe, other factors than central banks impact inflation – the eyepopping decline in money supply reveals one clear message. Headline inflation will come down, ‘hard.’

Excess liquidity vs. Equity Market Valuation

But there’s more ‘evidence’ that money supply flow is of great importance. For example, one of our favorite use cases of money supply growth in our MACRO-SENTIMENT-VALUATION investment is as a measure of excess liquidity.

The chart below shows our Excess Liquidity vs. Forward P/E ratio analysis. Here, we determine Excess Liquidity as year-on-year Money Supply Growth minus Nominal GDP growth. The rationale behind this definition of liquidity is that money supply growth that is being ‘unused’ by the real economy – measured as nominal GDP growth – is destined to hit financial markets. And the forward P/E ratio of US equities is a key result of excess liquidity, rising when financial market money is abundant and falling when a drought hits.

As the chart reveals, money is currently being drawn from equity markets at a historically rapid pace, suggesting a significant decline in the forward P/E ratio. But the opposite has happened. The earlier decline in the forward P/E ratio – caused by the bear market of 2022, but with positive earnings growth – is steadily being erased.

20% downside on the table

The forward P/E ratio of US Equities would have to collapse to around 16 to get valuation moving even remotely in the direction of Excess Liquidity. This suggests ‘a value’ of 3,560 for the S&P 500 Index based on realized earnings. However, we expect earnings-per-share numbers to decline significantly in the coming quarters, lifting the downside comfortably to 20%. Unless the Federal Reserve will start to actively accelerate money supply growth – it aims to do the exact opposite currently – Excess Liquidity-driven valuation will be a big risk to equities in the coming months. We remain underweight Developed, and Emerging Market Equities.

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