The Money Supply and the Stock Market: The Demise of a Leading Indicator

CFA Institute

The Money Supply and the Stock Market: The Demise of a Leading IndicatorAuthor(s): Michael S. RozeffSource: Financial Analysts Journal, Vol. 31, No. 5 (Sep. - Oct., 1975), pp. 18-20+22-24+26+76Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4477859 .

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SEPTEMBER/OCTOBER 1975 FAJ

by Michael S. Rozeff

The Money Supply

And the Stock Market

The Demise of a Leading Indicator

While few propositions about the stock market are universally accepted, most members of the financial community probably agree that changes in Federal Reserve Board monetary policy strongly influence changes in stock prices. In the past ten years, the importance of the rate of money supply growth to the economy and to the stock market has been increasingly recognized. For many stock market analysts, money supply movements are now treated as superior indicators of trends in central bank monetary policy and are frequently in- terpreted as providing information about future stock price movements. Margin requirements, the discount rate, federal funds rates, reserve requirements and statements by Fed officials are widely reported in the financial press and are accepted indicators of whether monetary policy is "tightening" or "loosening," with the expectation that a tighter monetary policy will be associated with falling stock prices and an easier monetary policy with rising stock prices.

For stock market forecasters, the prime reason for adopting the money supply indicator seems to have been Beryl Sprinkel's detailed application to the stock market by Friedman and Schwartz that business cycle turning points are associated with prior changes in the rate of growth of the money

stock.' In his books, Sprinkel articulates what I call elsewhere the "predictive" version of the monetary portfolio model to explain how changes in growth rates of monetary aggregates precede changes in the prices of stocks (and other financial assets) and precede changes in prices of consumer goods and services.2 The monetary portfolio model views investors as holding portfolios of such assets as stocks, bonds, durable goods and money. Inves- tors determine the fraction of wealth they wish to hold in the form of money. When the economy's money supply increases, investors find the money portion of their assets too large and attempt to restore the desired portfolio mix by purchasing other assets such as stocks, forcing their prices to rise.

Sprinkel views this sequence as consuming suffi- cient time that one can predict stock price changes given knowledge of past money supply movements. His key propositions are (1) that as an indicator, the money supply series leads stock prices and (2) that the astute investor can use this leading indicator to earn above-average returns in stock market investment. These assertions have gone largely unchallenged.3 Indeed, since Sprinkel's original study, Palmer, Reilly and Lewis have sup- ported Sprinkel's view that monetary change pre- cedes stock price change and Homa and Jaffee have developed a trading rule using money data which they report is more profitable than an equiv- alent-risk, naive policy of buying-and-holding

Michael S. Rozeff is Assistant Professor, College of Business Administration, University of Iowa. He gratefully acknowledges the comments of Jack Ken- nelly and William Kinney on an earlier version of this article. 1. Footnotes appear at end of article.

18 g FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1975



stocks.4 Thus there is a respectable body of opinion that regards the money supply as an indicator by which one can forecast movements in stock prices.

Efficient Market Model-An Opposing View

Monthly money supply data has been made publicly available (with a one to two month lag) in the Federal Reserve Bulletin since 1943, and weekly data has been released (with an eight to eleven day lag) since 1967. Both publications reach many investors. What effect does receipt of this information have on stock prices? As we have seen, the predictive monetary portfolio model says it has a delayed effect. According to an alternative view of how stock prices react to published reports of monetary data, profit-seeking investors will exploit a report's contents if they are relevant to stock prices so quickly that security prices will exhibit no systematically delayed reactions (of any consequence) to published money supply develop- ments.

The efficient market model also provides an ex- planation for the discounting of future events by the stock market. If information arises in the present that has implications for future stock prices, investor actions will alter the current price level so that the anticipated event is discounted in today's price. Since discounting can occur with respect to unpublished as well as published information, the stock market can be efficient with respect to unpublished information; that is, prices may fully reflect unpublished as well as published information. In the case of money supply movements, a situation can easily be imagined in which information (published and unpublished) becomes available which allows investors to anticipate (correctly) future money growth rates. Thus, in an efficient market, it would not be at all surprising to find that stock prices change in anticipation of money supply changes if investors make use of alternative sources of information to gauge the future course of the money supply. For example, the Fed might provide information about current and future money supply growth by official statements or by well-advertised actions such as altering margin or reserve requirements. Also, market ob- servers may draw inferences about future money supply growth by observing money market rates and current and expected Treasury financings.

If investors consider money supply data to be relevant for stock prices and if the stock market is efficient, then competition by investors trying to use reported information about changes in the money supply will result in a level of stock prices

that fully reflects new information when it is published, on the average. Investors may sometimes lag in reacting to information and they may sometimes anticipate information yet to be published, but on the average there is no systematic lag (of any economic consequence) in the market reaction to information. If there were such a lag, investors who noticed it would seek to buy (or sell) ahead of other investors, thereby altering the current stock price level. In the case of money supply data, numerous profit-seeking investors can easily obtain the data. Their rivalry to exploit any systematic lags that might develop implies that the data will be acted upon fully, so that current security prices will fully reflect (in the sense described above) the available money supply data.

How valid is a model of stock prices in which stock prices reflect available information? A large and growing volume of evidence (reviewed by Fama) supports this view. An extremely important and testable consequence of an efficient market is that investors cannot trade successfully on past data, since current security prices will have already changed in consequence of information obtainable from past data. That is, trading schemes that generate trading signals from data known to the market cannot generate above-average profits if the market has already fully exploited the data.

Most trading rules that have been tested have been unprofitable compared to buy and hold, providing evidence consistent with the efficient market model. It is thus anomalous to find Sprinkel's study and others proposing that stock price changes lag behind money supply changes to an extent that investors can formulate trading schemes of above-average profitability. The efficient market model leads to opposing conclusions: (1) that trading rules using past available money supply data will be useless, and (2) that if money supply changes do affect stock price changes, the stock market will change prior to, or contempora- neously with, the money supply change.

In the rest of this article I summarize extensive tests of Sprinkel's predictive model against the efficient market model. The tests show that current stock price changes are virtually unrelated to prior money supply changes and cannot be predicted profitably by trading rules using past money data; in addition, I show that stock market movements are related to current and future money supply movements. That is, money growth rates are not a leading indicator of changes in stock prices. Stock prices tend to coincide with, or even change pri- or to, money supply changes. I first examine Sprinkel's trading rule and explain why his evidence does not support his conclusions.

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1975 C 19



TABLE 1: Sprinkel Trading Rule Dates

Sprinkel's Execution Literal Execution Buy Sell S&P 425 Index Buy Sell S&P 425 Index

Aug. 1918 March 1920 5.66 7.31 Aug. 1918 March 1920 5.66 7.31 Aug. 1921 Sept. 1923 4.57 6.11 Aug. 1921 Sept. 1923 4.57 6.11 June 1924 Feb. 1926 6.45 10.10 Jan. 1924 Feb. 1926 6.84 10.10 Feb. 1927 Jan. 1929 10.96 21.22 June 1926 Jan. 1929 9.59 21.22 May 1932 Sept. 1936 4.27 15.17 July 1929 Jan. 1931 22.95 12.34 Feb. 1938 April 1946 10.89 18.02 March 1931 June 1932 13.45 3.80 April 1949 April 1953 14.66 24.84 Aug. 1932 Sept. 1936 5.94 15.17 Jan. 1954 May 1956 25.55 49.64 March 1937 July 1938 17.52 12.12 March 1958 Feb. 1960 44.97 59.60 Sept. 1938 Feb. 1941 11.81 9.64

Jan. 1942 June 1944 8.95 12.58 Aug. 1944 April 1946 12.67 18.02 July 1946 Oct. 1947 17.42 15.19 Sept. 1948 Apri l 1953 15.53 24.84 Feb. 1954 May 1956 26.12 49.64 Dec. 1956 April 1958 49.79 45.09 June 1958 Feb. 1960 47.62 59.60

Testing Sprinkel's Trading Rule Sprinkel's method of trading on money supply

changes depends on the relationship of stock prices and growth rates of the money supply to business cycle peaks and troughs as defined officially by the National Bureau of Economic Research (NBER). Sprinkel observes that common stock prices begin to decline four months prior to a business cycle peak while money growth rates turn downward about nineteen months prior to the peak, on average; he therefore concludes that decelerations of money growth precede downward changes in stock prices by 15 months. Conversely, at the trough of a business cycle money growth rates seem to lead stock prices by two months.

Applying the money supply indicator systematically to data over the years 1918 to 1960, Sprinkel reports an average annual compound yield of 12.5 per cent compared to a yield of 5.8 per cent for a naive buy-and-hold policy. His trading procedure is described as follows:

All funds were invested in stocks until monetary growth had declined 15 months, and then all funds were invested in bonds until monetary growth had risen two months.6

Can an investor apply this trading rule and earn extranormal profits? In applying the rule as stated, investors will find that it generates many buy-and- sell signals differing from Sprinkel's. For example, 15 months of declining monetary growth (by which Sprinkel means that a prior peak has not been ex- ceeded for 15 months) occurred as of January 1931, and again as of June 1932; but Sprinkel does not list sell signals on these dates. Sprinkel's reported trading dates and the dates arising from applying his rule literally are compared in Table 1. Applied faithfully (excluding, as did Sprinkel,

brokerage and dividends), the trading rule pro- duces a yield of 5.0 per cent per year, which is inferior to the 5.8 per cent buy-and-hold yield.

What explains the discrepancies between a literal execution of Sprinkel's trading rule and the trading rule dates reported by Sprinkel? Sprinkel's statement of his trading rule fails to make clear that a sell signal is given only after those episodes of 15 months of declining money growth that precede an NBER business cycle peak. Sim- ilarly, for buy signals the two months of rising monetary growth that give a buy signal are those preceding an NBER business cycle trough. Evidently, to earn the high reported returns, the investor would have had to predict business cycle peaks and troughs correctly, since the National Bureau generally identifies business cycles many months after their occurrence. Business cycle peaks and troughs are currently unidentifiable before the event.

We may conclude that in its current form the Sprinkel trading rule is an exercise in after-the-fact selection of particular peaks and troughs, an exercise that severely biases the results toward profitability of the trading rule, as shown by the fact that when executed literally, the rule actually results in rates of return lower than buy and hold. Investors cannot apply this trading rule and expect to earn extranormal profits without a further reliable selection method telling which monetary declines and advances to neglect and which to act upon. Such a method is not provided by Sprinkel.7

Testing the Predictive Monetary Portfolio Model Unfortunately, Sprinkel's graphical method of

finding what relationship if any exists between changes in stock prices and changes in money growth rates is a weak technique. He correctly em-

20 C1 FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1975



phasizes and interprets the monetary portfolio model as saying that unanticipated deviations from the normally expected money growth rate are the disturbances that result in changing stock prices. His measure of unexpected changes in money growth rates is simply the change in the growth rate from this period to the next, and therefore he logically seeks to relate changes in growth rates to changes in stock prices. Several problems arise in the way he obtains this relationship.

Among the serious difficulties in his method are the following: (1) He examines the relationship of money growth rate changes to stock price changes by plotting price levels of stock prices against levels of money growth rates and looking for changes in the levels of the variables. It is very difficult to identify with accuracy changes in variables by examing their levels graphically. (2) Any graphical procedure is automatically subject to possibili- ties of error and bias not found in a statistical ap- proach. It is useful to check the conclusions reached from a graphical analysis with statistical methods if possible. (3) He does not provide any justification for singling out only the monetary events associated with business cycles. By doing so, he throws away a great deal of information about movements of money and stock prices at other points in time and treats all monetary declines and advances at business cycle turning points as of equal importance even though their magnitudes differ.

A statistical method that overcomes these difficulties and provides a powerful test of the influence of money supply changes on stock prices is linear regression. This method gives an unambigu- ous measure of the fraction of the variation in stock prices associated with (or "explainable" by) past changes in money growth rates. In addition, with this statistical method, a statement can be made of the likelihood that any pattern revealed in the data could have occurred by chance. In my use of this method, I seek to find the extent to which the variation in stock returns (the dependent vari- able) is associated with or explained by movements in money growth rates (the independent variables).

Examining the period 1918 to 1960 and using Sprinkel's monthly data, changes in stock prices were first related to 17 past monthly changes in growth rates of the money supply. Going back 17 months covers the reported 15-month lead of the money series. The money supply changes explained a mere one per cent of the variation in stock prices; and one could not confidently conclude that the weak relationship observed was not simply the result of chance. Changes in money growth rates two and 15 months prior seemed to have no partic-

ular importance for current stock price change. Over various time periods from 1918 to 1972 and with various measures of the money supply, the money data available to investors generally explained only one to four per cent of the variation in stock prices. In the subperiod running from 1948 to 1960, this percentage reached a high of 10 before plunging to zero over the decade of the 1960's. The natural conclusion suggested by this evidence is that current changes in stock prices are for all practical purposes unrelated to past changes in money growth rates. The relationship is, in any event, far weaker than Sprinkel's statements seem to suggest and in most cases statistically in- significant.

It is possible, though unlikely, that this weak relationship could be used in a profitable trading rule. I tested this possibility by devising trading rules that predicted stock returns on the basis of their relationship with past changes in available money supply data. The trading rules simulate pur- chases of a diversified group of securities (i.e., an index).8 (The rules were careful to provide the hypothetical trader only with available published data for his decision; until 1967 money data was generally published with a lag of one to two months.) It was necessary to adjust buy-and- hold returns for risk but as this adjustment al- ways lowered the buy-and-hold returns, it invari- ably cast the trading rules in a more favorable light, thus working in the "correct" direction for present purposes.

Table 2 compares the average annual compound yields for a trading rule which uses past growth rates of the money supply to a comparable strategy of buy and hold. In the table, "net returns" refers to trading rule returns after deduction of a one per cent round-turn commission cost while gross returns neglect commissions. The average returns from the non-trading strategy exceed those from the trading strategy net of commission costs despite the downward adjustment in by-and-hold returns. If commissions are excluded, the trading rule returns are fairly close to buy-and-hold returns

TABLE 2: Comparison of Predictive Trading Rule Re- turns To Buy-and-Hold Returns, Annual Yields

Trading Rule

Gross of Net of 1% Buy-and-Hold Time Period Trans. Costs Trans. Costs Returns

10/1956-10/1962 0.0526 0.0268 0.0715 10/1956- 4/1967 0.1027 0.0769 0.1193 10/1956-11/1970 0.0698 0.0436 0.0891 11/1962- 4/1967 0.1743 0.1484 0.1747 5/1967-11/1970 -0.0217 -0.0487 0.0293

22 O FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1975



but, in view of the large variability inherent in stock returns, not significantly different from buy- and-hold returns. It is evident that the trading rule is not profitable in comparison with a buy-and- hold policy.

In a trading-rule test, available money data gives no indication of profitability and is in fact unprofitable when allowance is made for commissions. The most important implication of this result for investors is that published money supply figures seem to be worthless as (leading) indicators of the future direction of stock prices. Current stock price movements are virtually unrelated to changes in the money supply in the (near or distant) past, hence are highly unlikely to prove profitable, either alone or contributing to a more complex indicator. Because the most important feature of an efficient stock market is the uselessness of past available data for profitable prediction, we may regard this evidence as consistent with the efficient market view of price formation and inconsistent with the predictive version of the monetary portfolio model.

Testing a "Non-predictive" Monetary Portfolio Model

The lack of a relationship between stock returns and past money data is at first glance a distressing result for monetarists (those economists who have stressed the key role that the money supply plays in affecting the price level). However, the same linear regression technique that demonstrates the unim- portance of past changes in the money supply to stock prices shows that the current or contempera- neous money supply change is quite important. The monthly money data in the period since World War II, for example, can explain about four to 10 per cent of the variation in stock returns once the current money data is taken account of.

Random influences have a greater chance to cancel out the longer the period. My results con- firm those of Hamburger and Kochin who reported that fully one-fourth of current stock price change is associated with changes in money growth rates.9 This finding is not inconsistent with an efficient stock market since current data cannot be used to predict current stock prices.10

Changes in monetary growth rates are therefore strongly linked to the stock market once the current changes are considered, a result that ac- cords with the monetarist view of Sprinkel and others that monetary policy affects markets. But there is no evidence of long lags in stock market reaction, hence of any possibility of profitably predicting stock prices, using changes in monetary policy; past data has been fully reflected in stock

prices of past periods, hence cannot help to predict future movements. In sum, a non-predictive version of the monetary portfolio model seems to fit the facts while a predictive version does not.

Anticipation of the Money Supply Suppose it is in fact the case (1) that information

may be available to the stock market that permits an accurate assessment of future money supply growth and (2) that current stock prices reflect this information. At a minimum, if past money supply growth provides an indication of future money growth, the implications of past money growth for future money growth would be discounted in an efficient market. Beyond this, current data on the monetary base, money market conditions, etc., may provide a basis for reliable forecasts of future money growth. If the stock market consistently and accurately anticipates future monetary growth, we expect to find a relationship between current price changes and future realized money supply changes.

To test for this relationship, we added future changes in money growth rates to the current and past terms already present in the linear regression explaining currcnt stock returns. On a monthly basis, in all periods and subperiods and with several definitions of money, the result is a remark- able improvement in the association between stock returns and changes in money supply growth. Changes in monetary growth rates now explain 15 to 20 per cent of the variation in stock returns. During the 1960's, for example, the power of the money terms to explain stock returns jumps from about two to 16 per cent once we include future money changes. This statistically significant association shows that an important fraction of the fluctuations observed in current stock prices can be linked to subsequent fluctuations in monetary growth rates. The association is also a positive one; higher than usual stock price rises are associated with subsequent higher than usual money growth rates. The lead of stock price changes over changes in money growth rates is one to two months.

The lead of stock returns over future monetary growth persists under several different money supply definitions and using several types of data weekly, monthly or quarterly. It can be shown to persist under a more rigorous test. If we examine the available series of observations of money growth rates, we can observe (using regression methods) that when money growth is disturbed from its normal course, the disturbance persists for several additional months. Thus a higher (lower) growth rate of the money supply observed today portends a higher (lower) growth rate for the next several months. This tendency for monetary dis-

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1975 W 23



turbances to persist means that knowledge of past money supply growth helps to predict future money supply growth. It is possible that stock returns seem to anticipate future money growth rates because stock prices adjust to the current growth rate and the disturbance in the current growth rate is expected to persist.

To test this conjecture, I constructed new measures of future unanticipated growth rates that took into account the tendency for monetary disturbances to persist. When stock returns are related to these improved predictions of money growth rates past money terms lose virtually all signifi- cance while current and particularly the following two months' money terms continue to display a clear relation to current stock returns. This is evidence that stock returns anticipate future monetary disturbances by use of information over and above knowledge of current and past growth rates of the money supply.

The finding that stock returns anticipate the growth rate of the money supply complements the absence of a lagged effect of the money supply on stock prices discussed earlier. Not only is the money supply a poor indicator of future change in security prices, the current movement of stock prices provides information on future money supply movements. This relationship of money and stock prices, which is the reverse of what money supply watchers have been led to expect, under- scores the futility of attempting to predict stock price movements with money supply data. It gives further evidence of an efficient stock market for which money appears to matter, although the linkage operates in an unexpected direction.

At least two other possible interpretations of these findings should be mentioned briefly. The movement of stock prices prior to money supply changes may be taken as evidence that the monetary authorities are reacting to prior stock price movements. This interpretation is consistent with the observed relationship but does raise the difficult question why the Fed would decrease monetary growth after observing decreasing stock returns and vice versa-a policy which, in the con- ventional view, would imply still lower stock prices. A second possible interpretation is that stock prices and Federal Reserve authorities react to the same information but with stock prices reacting more quickly than the Fed. Rising interest rates, for example, are accompanied by falling stock prices, other things equal. Rising interest rates are also on average followed by lower monetary growth rates although the relationship is a weak one. Joint relationships with variables such as interest rates may be able to explain why stock

prices fall before money growth rates fall without appealing to the monetary portfolio model. Hope- fully, further research will help to illuminate the factors lying behind the observed lead of stock returns over money supply growth.

Mechanical Trading Rules A common criticism of a trading rule test of a

stock market indicator such as mine is that it is too simple and mechanical and eliminates human judgment. Too often when a scheme is shown to fail, its proponents argue that it cannot be expected to be effective in all situations, that judgment is required and that in changing situations other factors should influence the investment decision. (Unfortunately, the other factors are usually left unspecified.) To show that mechanical trading schemes of the type used to test the worth of available money supply data are not doomed to failure simply because they are mechanical and use only one set of data, I tested the profitability of a trading rule which allows the investor to use several future observations of growth rates of the money supply (see foot- note 10)-data unavailable to the ordinary investor. The basis of the trading rule is precisely the same type of linear regression equation described previously, in which stock returns are dependent upon money supply growth rates. Table 3 compares the trading rule results with buy-and-hold returns, using compond average annual rates of return. As before, buy-and-hold returns have been adjusted to compensate for the times when the trading rule moves the investor out of stocks and into a virtually risk-free investment (commercial paper).

The results shown are typical of those trading rules tested that allowed the investor to use unavailable data. Trading rule returns generally exceed buy-and-hold returns even after deduction of trading costs. For example, over the 15-year period from 1956 to 1970, the trading rule netted 10.66 per cent per year compared to 8.43 per cent (risk- adjusted) for buy and hold. (Notice that, in the period from November 1962 to April 1967, the

TABLE 3: Comparison of Trading Rule Returns (Using Unavailable Data) To Buy-and- Hold Returns, Annual Yields

Trading Rule

Gross of Net of 1% Buy-and-Hold Time Period Trans. Costs Trans. Costs Returns

10/1956-10/1962 0.1447 0.1222 0.0657 10/1956- 4/1967 0.1379 0.1122 0.1112 10/1956-11/1970 0.1336 0.1066 0.0843 11/1962- 4/1967 0.1287 0.0964 0.1660 5/1967-11/1970 0.1210 0.0900 0.0383

24 D FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1975



trading rule was inferior to a buy-and-hold policy.) The large variability in monthly stock returns can easily give rise to such exceptions over relatively short subperiods; this problem can only be over- come by testing a trading scheme over many independent time periods or with many independent sets of data. The significant superiority in this case of the trading rule given unavailable data shows that mechanical trading rules can be profitable and that therefore, when they fail to be profitable, the failure cannot be attributed to their mechanical nature or their neglect of "judgment" or other un- defined factors.

For readers who wish to test stock market indicators by devising trading rules, some words of caution are in order. First, the profitability of a trading rule depends to a considerable extent on whether or not it uses data available to an investor. As I have shown, a trading rule using unavailable data may appear to be profitable. To test a rule one should not simply obtain data after the fact and assume that it was available at some prior time. For example, we now know the gross national product for the 2nd quarter of 1970. As of June 30, 1970, however, this data was not yet published. Sprinkel's trading rule fails most importantly on this count since it relies on a knowledge of business cycle turning points that was unavailable when investment decisions were made. Second, dividends should be included in computing stock returns and brokerage costs charged for any trades undertaken. Omission will bias the comparison of a trading rule with buy and hold. Third, a trading rule that is profitable only on that body of data from which the rule was developed proves nothing. It is usually possible to find a scheme that works in hindsight. A valid test, on the other hand, requires an independent body of data. Fourth, if higher risk assets earn higher returns than lower risk assets, a valid comparison of a trading rule to buy and hold requires holding the risk factor constant. Otherwise a trading rule can be made to look profitable simply by selecting higher risk assets.

Conclusions It is simply not true that past money supply data can provide a profitable guide to investment timing or improve a portfolio's rate of return. Information is reflected in stock prices so rapidly that published data tells the investor virtually nothing about the future changes in stock prices. In particular, Sprinkel's trading rule, which uses the money supply as in indicator of future stock market movements, cannot be executed without prior knowledge of business cycle turning points and, when ap-

plied mechanically, does not outperform a naive buy-and-hold policy.

Not only do stock returns reflect money data when published, they also anticipate future monetary growth to some extent. But this is what we should expect in a world in which changes in the rate of growth of the money supply affect stock prices and an efficient stock market strives to anticipate future monetary growth rates. .

Footnotes 1. See Milton Friedman and Anna J. Schwartz,

"Money and Business Cycles," Review of Econom- ics and Statistics, Supplement (February 1963), pp. 32-64. Also, see Beryl W. Sprinkel, Money and Stock Prices (Homewood, Illinois: Richard D. Ir- win, 1964), and Beryl W. Sprinkel, Money and Markets: A Monetarist View (Homewood, Illinois: Richard D. Irwin, 1971).

2. A complete technical treatment of the models and the empirical tests summarized here can be found in Michael S. Rozeff, "Money and Stock Prices: Mar- ket Efficiency and the Lag in Effect of Monetary Policy," Journal of Financial Economics (Septem- ber 1974), pp. 1-57.

3. The first detailed published criticism of Sprinkel's position is contained in Richard V.L. Cooper, "Ef- ficient Capital Markets and the Quantity Theory of Money," Journal of Finance (June 1974), pp. 887- 908.

4. See Michael Palmer, "Money Supply, Portfolio Ad- justments and Stock Prices," Financial Analysts Journal (July/August 1970), pp. 19-22; Frank K. Reilly and John E. Lewis, "Monetary Variables and Stock Prices," Working Paper No. 38 (March 1971), School of Business, University of Kansas, Lawrence; Kenneth E. Homa and Dwight M. Jaffee, "The Supply of Money and Common Stock Prices," Journal of Finance (December 1971), pp. 1056- 66.

5. A useful summary of the theory and evidence is Eu- gene F. Fama, "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Fi- nance (May 1970), pp. 383-417. The random walk model of stock prices is a special case of the efficient market model.

6. See Sprinkel, Money and Stock Prices, pp. 149- 151.

7. Sprinkel does emphasize that investors will have to employ other information such as total reserves, free reserves, gold flows, employment, industrial produc- tion, etc., in order to decide whether business cycle peaks or troughs are occurring but since stock prices are among the best leading indicators, it is doubtful this data will be useful.

8. The results in Table 2 refer to a trading rule which uses unrevised seasonally unadjusted past money growth rates. Seasonally adjusted data give comparable results. The regression equation generates pre-

concluded on page 76

26 El FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1975



rate of return ranges from 9.1 to 23.4 per cent. The range of compound annual rates of return narrows as the investment planning horizon lengthens. Over a 25-year investment horizon (Table 7) the range in Exhibit 3 is 1 1.2 to 12.9 per cent. Here, realized growth in dividends clearly dominates.

In Table 8, we illustrate, using Exhibit 3 from Tables 4,5,6 and 7, how the range of returns zeros in on 11.3 per cent-the realized dividend growth (six per cent) plus current yield (5.3 per cent)-as the investment horizon lengthens. In the long run, the realized growth rate in dividends is seen to dominate both the return and growth expectations of investors. The problem of investing becomes primarily one of forecasting the economic success of the firm as it pertains to future dividend pay- ments. Investment timing, or playing investor psy- chology, is a game within a game, which need not be played to produce acceptable investment results.

Summary and Conclusions In theory, the expected rate of capital appreciation equals the expected growth rate in dividends. During the postwar period, earnings growth and dividend growth were very close. Earnings growth, which occupies the thinking of most investors, is actually a surrogate for what really matters, namely, dividend growth.

The change in spread between expected return and dividend growth is the lever on stock prices that causes expansion and contraction in multiples. The current yield is a handy measure of the spread, both in real and in nominal terms. The relatively narrow changes in the implied spread (R-G) expe- rienced during the postwar period may understate the volatility that will occur in the future. The current spread between expected return and growth

approaches that of the 1947 bear market; however, the decline in stock prices has been greater owing to the fact that the 1973 market high was the low watermark in terms of spread, and the change in spread from top to bottom was the largest in the postwar period.

Assuming economists are correct when they forecast a three to four per cent real growth, then the expected rate of real return currently im- pounded in stock prices ranges from 8.3 to 9.3 per cent. The most likely trading range of the S&P 425 is currently between $65 and $130, unless investors come to view the real growth prospects for the US. to be below three per cent or require unprece- dented real rates of return for investing in stocks. Currently, the S&P 425 is priced to return, in nominal terms, between 14 and 15 per cent assuming a six per cent trend in inflation. The fact that the trading range for stocks is large is a result of the economic forces which create them. In the short run, changes in investor expectations for return and growth dominate in determining realized return. As the investment planning horizon lengthens, the realized growth in dividends becomes the dominant factor.

In retrospect, today probably will appear to have been a good time to have invested in stocks. .

THE MONEY SUPPLY Footnotes continued from Dage 26

dictions for stock returns which are compared to rates available on commercial paper. Sell signals occur when stock returns are expected to be less than on commercial paper; the investor then buys paper. Buy-and-hold returns have been adjusted to compensate for the periods of time when the trading rule places the investor out of stocks and into the virtually risk-free commercial paper as follows: If the trading rule is in stocks x per cent of the entire trading period, the buy-and-hold returns are calculated assuming that x per cent of each investment dollar was initially placed in stocks and (100-x) per cent in commercial paper.

9. See Michael J. Hamburger and Levis A. Kochin, "Money and Stock Prices: The Channels of Influ- ence," Journal of Finance (May 1972), pp. 231- 49.

10. Furthermore I was able to use the relationship of current stock returns to current money changes from 1956 to 1967 to simulate a profitable trading rule. The profitability depended on knowing the current money supply in advance of its publication one month hence. After 1967, this trading rule loses its profitability. I attribute this to the weekly release of money data which provides all investors with a great deal of current information before the month is out. Knowledge of the current money supply therefore is no longer especially profitable.

DIVIDEND NOTICE

MIDDLE SOUTH UTILITIESs INC. The Board of Directors has this day declared a dividend

of 3112 ? per share on the Common Stock, payable October 1, 1 975, to stockholders of record at the close of business September 12, 1975.

August 22. 1 975 | Secretary

THE MIDDLE SOUTH UTILITIES SYSTEM Arkansas Power & Light Company Louisiana Power & Light Company Arkansas-Missouri Power Company Mississippi Power & Light Company

New Orleans Public Service Inc

76 O FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1975



The Money Supply and the Stock Market: The Demise of a Leading Indicator

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