Investors are regularly bombarded with a plethora of economic data relating to unemployment, consumer confidence, housing starts, inflation measures and more.
Some people might feel this is more information than they need, but the fact is it might not be enough. That's because there's one useful economic indicator that is frequently overlooked: the nation's money supply -- in particular, the narrowest definition of money supply, M1.
M1 is a particularly good way to get an honest angle on how the economy is performing. It includes all hard currency in circulation as well as in people's checking accounts.
For example, anyone paying attention to this indicator might not have been surprised by the unexpectedly weak reading on the economy earlier this month. Real gross domestic product rose by just 0.6% -- the slowest rate in four years. That was a big revision of the initial report last month, which showed an increase in real, or inflation-adjusted, GDP of more than twice that, or 1.3%.
But as the chart below shows, M1 growth tends to rise when the economy is picking up and fall when the economy is slowing down. And it has been on a downward trajectory since May 2003.
For example, M1 growth was slowing back in 1987 as the economy headed into recession and it actually contracted in 1989. So you could say that M1 provided an early warning signal -- although the stock market crash of 1987 was a huge clue, too.
M1 growth picked up again in 1990 and continued on an upward trajectory over the next two years before slowing down again in 1993; by 1996, when former
Chairman Alan Greenspan made his famous statement about the stock market's "irrational exuberance," M1 was actually contracting.
M1 continued to contract throughout 1997, the year that saw the Asian financial crisis and ensuing contagion that spread throughout the region and finally to other emerging markets such as Russia and Brazil. However, at this point M1 was actually at odds with the U.S. economy, which continued to buzz along despite these shocks to the global financial system.
It's the Money Supply, Stupid
Source: Federal Reserve
M1 subsequently moved back in sync with the U.S. economy the following year, with both expanding up until the dot-com bust in 2000, at which point they both began to contract.
Ironically, the terrorist attacks of Sept. 11, 2001, proved a turning point for both M1 and the economy, with Greenspan injecting a large dose of liquidity into the financial markets, lowering the fed funds rate to its lowest point of 1%. The central bank also injected liquidity via the market for repurchase agreements, another important monetary policy tool.
That caused M1 to spike almost vertically. It then came crashing back down almost as quickly, briefly contracting in December 2001 before resuming its upward trend. M1 growth subsequently peaked at 3.53% in May 2003 and has been on a downward trend ever since.
Again, the correlation between this measure of money supply and the economy seems to have faltered, as the economy has been doing better since 2003 than the M1 supply would indicate. However, no indicator by itself is a perfect gauge of the economy, and M1 is no exception.
The takeaway from all of this is that a contraction in M1, as indicated in the chart by a drop in the growth rate below 0%, can be a sign that the economy is getting weaker. And that line has been breaking into negative territory on an increasingly regular basis since late 2005.
The key is to keep watching this indicator as we go forward into 2007. You can keep track of M1 changes by downloading the Fed data into Excel and then generating the appropriate graphs. Information on M1 can be found
on the Federal Reserve's Web site.
Sam Patel, CFA, is the manager of mutual fund research for the TheStreet.com Ratings.
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