To Know What’s Ahead For The Market, I’m Looking Back…

Markets are returning to normal… but we are still a long way off from where things were at the beginning of the year.

To understand where we are, take a look at the chart below. It shows the S&P 500 with my Income Trader Volatility (ITV) indicator.

ITV is normalized so that the absolute value of the indicator is comparable over time. That means a reading of 30 today is equivalent to a reading of 30 in 1929.

The only time ITV recorded a higher level than it did last month was in 1929. That tells us that this is a significant event. Other times ITV moved to this level included the October 1987 crash, the bottom of the bear market in 2009, and at the beginning of World War II.

As I continue to search for a similar period of history, this time frame seems worth considering. Stocks crashed in 1937 as government spending declined. Officials at the Federal Reserve and the Treasury Department thought the crisis was over and the economy could stand on its own.

Then, world events turned. There was one calamity after another as nations went to war with each other. The bottom came in May 1942, after it became clear that the Battle of Bataan marked a turning point in the war.

The Fed’s Role Today

What’s interesting about this time period is that the market was already turning lower ahead of the important news stories.

Overlooked in the recent selloff is the possible role of the Fed. The chart below shows the Fed might have played a role in the decline.

The black line in the chart is the S&P 500. The blue line at the bottom is the quarter-over-quarter rate of change (ROC) of the money supply. Red lines show transitions from expansionary monetary policy to contractionary policy.

Money supply is shown as 2, a broad measure of the amount of cash available in the economy. I use a 13-week ROC because I am isolating short-term changes in policy. In the 1970s and 1980s, traders closely followed money supply because changes tended to lead the stock market.

Now, money supply still seems to play a role in the stock market since investment banks and hedge funds can borrow more money for investing when the Fed is following an expansionary policy.

As the chart shows, when the growth in M2 falls below 2%, a selloff follows. The market then adapts to the new policy and stocks can move up in the face of contractionary policies. It’s the transition when the greatest risk to the stock market occurs.

The 2% level is important because that is the Fed’s inflation target. Increasing the money supply by 2% can be considered a neutral policy, which is why I drew the dashed line at 2%.

Based on money supply, a market decline was almost inevitable. The depth of the decline was not related to the Fed’s action, but the decline might not have been as steep if the Fed wasn’t following a contractionary monetary policy.

What All This Means

The chart shows the Fed reversed course. Now the market trend will be determined by global events. Here’s where we face risks similar to the world in the 1940s. There will be a series of events related to the coronavirus.

We should see a recession, and the recession could include a credit crisis. It could create a crisis in the European Union as northern countries favor contractionary policies while southern countries depend on expansionary policies. These events aren’t mutually exclusive. Both could occur and, in fact, I believe both will occur.

There are other events that will flow from the recession, and history says we should expect volatility. The normal market environment is more likely to be similar to the volatile 1940s than the bullish 1990s.

For now, it looks like we will enjoy a tradable bounce. I’ve been keeping busy trying to identify “bonus dividend” trades with the least amount of risk possible — and I’ll be sending one out to my Maximum Income readers either today or tomorrow. We’ve been pretty successful so far in this effort, and there’s no reason to think that can’t continue.

If you want to know more about the “bonus dividend” strategy we’re using to earn income in this market, check out this report.