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TheStreet Open House

Follow the Money (Supply): Why Stocks Are Headed for Trouble

Stocks in this article: SPY

NEW YORK (TheStreet) -- Before fundamentals, technicals, interest rates, sentiment or anything else, the bottom line of why stock prices go up or down is money supply.

If money is available, one of the places it can go is the stock market. That is a necessary but not sufficient condition for the market to rise. But if not enough loose money is available, all the fundamentals and technicals in the world won't matter. The market has to go down.

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That is why the most important statistics to follow with regard to market trends is money supply. There are several measures for this, but the most prominent are the M1 and M2 numbers published by the Federal Reserve every week.

M1 consists of physical money in circulation and demand deposits, which are deposits that can be withdrawn without prior notice. M2 consists of M1 plus savings deposits, time deposits below $100,000 and money-market balances.

If we consider the kind of money that enters the market to bid up stock prices, M2 is a more accurate measure of what can bid up a security on demand than M1 is.

Money-market funds can be liquidated and used to invest almost immediately except in times of market stress. The only minor exception is time deposits, which can be liquidated and then invested only at certain times, but below $100,000, and that time frame is usually rather short.

What is not directly relevant to M1 or M2 is the monetary base, which is what is directly affected by quantitative easing, the Fed's bond-buying program.

When the Fed buys bonds, the money it buys bonds with goes directly to the monetary base via some bank which holds the money. It doesn't necessarily go into the money supply.

A bank can decide to simply do nothing with the money and keep it at the Fed, storing it as excess reserves outside the economy. Money stored as excess reserves cannot be used to bid up stock prices, or any other prices for that matter, until those excess reserves are loaned. They then become part of M1 or M2.

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