M2 Money Supply (by Boston Wealth)

M2 includes a broader set of financial assets held principally by households. M2 consists of M1 plus: (1) savings deposits (which include money market deposit accounts, or MMDAs); (2) small-denomination time deposits (time deposits in amounts of less than $100,000); and (3) balances in retail money market mutual funds (MMMFs). Seasonally adjusted M2 is computed by summing savings deposits, small-denomination time deposits, and retail MMMFs, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.

M2 is a good gauge used to track inflationary price pressures when it is rising. This is due to the fact that real output won't be able to keep pace with money supply growth. The recent reduction in M2 can be seen as deflationary if one defines deflation as a reduction in the M2 money supply. So we might be experiencing deflation and inflation is the least of our worries. This can threaten the economic recovery.

Here is the problem I see: If this decline in the money supply continues, it can lead us right back into economic contraction and then ultimately deflation.

The Feds are in charge here: They can influence money supply by open market operations, changing the discount rate, and by changing the reserve requirements.  Open market sales by the Fed decrease the money supply and likewise open market purchases increase the money supply.  Reducing the discount rate by the Fed, encourages banks to borrow reserves, thus increasing the money supply.  The opposite happens when the Fed increases the discount rate.  Finally by changing the reserve requirements, the Fed can increase the money supply by reducing the reserve requirements.  One can keep an eye on open market operations by the Fed here:  http://www.newyorkfed.org/markets/openmarket.html

Each year can be marked as a positive liquidity year wherein we have money supply growth, also known as M2 and positive credit expansion, i.e. bank lending. Average P/E in a liquidity year is 19.1. Average P/E in a negative liquidity year is 11.1. Data goes back all the way to the early 1900’s.

Let's just take a look and see in pictures how abysmal bank lending has been so far:

 

 
 
So assuming we have continued growth of M2 into 2010 and the banks start lending again and ease credit requirements, and assuming an earnings estimate of $58.12 for the S&P 500 for 2010, using top down operating earnings, we could see 1,110 on the S&P in 2010. If the opposite takes place and we stall with M2 and head towards a deflationary period and banks continue to remain very strict with their lending policies we could see $58.12 x 11.1 = 645 as a low for 2010.  Using bottom up operating earnings which are always more optimistic we would be using $75 for S&P earnings and the range would be 1,432 to 832 on the S&P 500.  These are the bullish scenarios.

The top down approach as the name suggests looks at the top level first. So the analyst is primarily concerned with how the economy is doing first and whether is is doing good or not.  Top down analysis includes economic, financial, and policy models.   Then the analyst will look at industries which will do well in the given economy and then the analyst will look at the company’s which will do well in the given sectors.  The bottom up approach is exactly the opposite of the top down approach and the analysts using this approach generally pick a company and then see how that company is performing. They are generally not concerned about the state of the economy. Bottom up analysts bacially ignore broad sector and economic conditions and instead focus on the individual attributes of a company

Utilizing reported or GAAP earnings, the type the bears like to use, we would use 53 as the S&P earnings for 2010 and the range would be 1012 to 588 on the S&P 500 depending on whether we had M2 growth and favorable credit conditions to declining M2 growth and tight credit conditions respectively. 

Let's see in historical context how skewed P/E is based on reported earnings:

So to recap:

Utilizing bullish bottom up operating earnings 2010 S&P 500 range:   1,432 to 832
Utilizing not as bullish top down operating earnings, 2010 S&P 500 range: 1,110 to 645
Utilizing what the bears like to use, i.e. reported earnings, 2010 S&P 500 range:   1,012 to 588

There now bulls and bears can see the big picture using one metric: M2 and credit to evaluate fair value of the S&P 500 for 2010.