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

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.

Mixed Signals Abound: Tough Decisions: Jim Cramer’s Best Blogs

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M1 consists of physical money in circulation and demand deposits, which are deposits that can be withdrawn without prior notice.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.

Jobs Report Allows Fed to Focus on Employment Instead of Inflation

Broadly speaking then, the M2 level is the relevant metric here. We can see in the latest report for the second quarter using the broadest average available on the spreadsheet, absolute M2 has gone up $80 billion. That's an increase of 0.7% for the quarter.

Since then, the S&P 500 measured by the SPDR S&P 500 ETF Trust (SPY), an exchange-traded fund, has increased just over 7%, or about 10 times the relative increase in money supply. Considering reserve requirements for banks with over $89 million in deposits is 10%, the 10 times relative increase in the S&P over the money supply makes a bit of sense.

A word of caution, though: There is not, nor will there ever be, an exact 10 times correlation between an increase in money supply and an increase in the S&P for any given quarter.

Money can come always come in from other directions and can be used to consume or spend elsewhere besides the market, and the market can always go down despite an increasing money supply.

There is no tracking individual human action with certainty. All this tells you is that the current market level is probably rather close to maxing out the amount of available money, and reserves available to bid up stock prices are more likely than not wearing pretty thin.

What this means is, ultimately, if money supply does not start to increase much quicker and very soon, say during the next three weeks, then someone is going to hit a sell order and there won't be enough loose money available to meet that market order at current stock prices.

Regardless of fundamentals, technicals or anything else, stock prices will likely trend down from here. The money just isn't there to support the market at current levels.

4 Stocks Warren Buffett Is Selling in 2014

At the time of publication, the author was short SPY.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

More from Opinion

AAP Exclusive: Cramer Says The President is No Longer on the Side of the Bulls

AAP Exclusive: Cramer Says The President is No Longer on the Side of the Bulls

Why It Makes Perfect Sense for Netflix and Amazon to Buy Up Movie Theaters

Why It Makes Perfect Sense for Netflix and Amazon to Buy Up Movie Theaters

2 More Reasons to Sell All Your Stocks and Run Away

2 More Reasons to Sell All Your Stocks and Run Away

Sean Hannity's Link to Trump Lawyer Raises Questions: Doug Kass Insider

Sean Hannity's Link to Trump Lawyer Raises Questions: Doug Kass Insider

Netflix Blowout Earnings Remind Investors of One Thing: This Company Is a Beast

Netflix Blowout Earnings Remind Investors of One Thing: This Company Is a Beast