SP500 Now Really Overvalued Versus M2

Most of the time analysts speak of the stock market getting overvalued in relation to earnings, dividends, book value, or some other "fundamental" factor.  This week's chart looks at that question in a different way, comparing the current level of the SP500 to M2, as a measure of how much total "money" there actually is. M2 counts how much real currency exists (dollar bills), plus it includes things like checking account levels, money market funds, and other things which are fascinating to economists but not essential for this discussion. 

M2 has grown over time, which is natural as GDP grows.  Sometimes the Fed and the Treasury department screw it up, though, creating too much or too little money.  They did that in a big way, printing a bunch of extra money in 2020 in response to Covid.  They hoped that by spreading a lot of money around, they could keep the economy afloat even though states were shutting down business activity due to the pandemic.  That money printing worked to some extent, but it had the significant side effect of causing 9% inflation for a brief time.

The Fed has tried to push the toothpaste back into the tube, and raw M2 saw a 5.7% drawdown as of its low point in October 2023.  That was the biggest raw decrease in the history of M2, which dates back in official statistics to 1959.  But the stock market has continued marching higher in spite of that drop in money supply, and so now we are seeing a fairly extreme reading for the ratio of the SP500 to M2 shown in this week's chart.  It rivals the peak we saw in August 2000, at the peak of the SP500 tied to the Internet Bubble. 

Seeing the SP500/M2 ratio get up above about 0.2 has been good enough to mark ordinary major stock market tops whenever it has happened since the 1959 start of the M2 data.  2000 was a rare exception of seeing it go far beyond that level.  And now we are seeing that 2000 high level get challenged once again in 2025.

Now, any valuation metric is only going to tell us about a condition.  It is not a "signal", and it will not tell us when such a condition is going to matter.  Valuation statistics are horrible as market timing tools.  Their main function is to give an idea of how bad things could get in the aftermath, once the market realizes it is overvalued and decides to try to do something about that.  Saying that the market is overvalued is about as useful as saying that it is overbought.  Such words do matter, eventually, but not on anyone's individual schedule. 

There are two ways to get this SP500/M2 ratio back down to a more historically normal level.  One is to have prices stay where they are, and print a bunch more money, which raises the denominator of that ratio.  The other is to keep the money supply the same, but to have the SP500 come down a lot in its price level, which is what we saw after the 2000 and 2007 peaks.  Neither was a pleasant experience.

And that is not to say that the ratio absolutely has to come down this time, just because it has always done so before.  Maybe it will find a comfortable new level up here.  There does seem to be something magical, though, about that 0.2 level for this ratio.  If the amount of money is not enough to keep prices aloft, then like the dwindling number of chairs in a musical chairs game, it can set off a response by investors who seek to find enough money to keep playing, or to cover their positions when compelled by margin clerks to do so.