Recent focus on elevated price-to-earnings (P/E) ratios in the stock market, including forecasts of low future returns in the S&P500, motivated me to examine the market’s valuation. As a follower of passive index fund investing, I began to wonder if the market is really set up for a decade of low returns. I intend to write a series of blog posts inspecting the relationship between the Cyclically Adjusted Price-to-Earnings (CAPE) ratio and the US M2 money supply to assess whether current market valuations are as extreme as traditional P/E ratios suggest.
Background and Hypothesis:
As many know, the Federal Reserve initiated a rapid interest rate increase cycle in March 2022, the most aggressive tightening since the early 1980s. This, coupled with concerns about market valuations, has raised questions about the potential for future market performance.
I performed an analysis focusing on the M2 monetary aggregate, which represents the total of US cash, liquid checking and savings accounts, certificates of deposit, and retail money market funds in circulation. M2 is primarily geared towards liquid assets held by individuals. The Federal Reserve has overseen a significant expansion of M2, particularly since the 2008 financial crisis and further accelerated in response to the 2020 pandemic.
My central hypothesis is that the current elevated P/E ratio of the stock market can be highly correlated to the increase in the M2 money supply. Adjusting the market’s P/E ratio by M2 may reveal that market valuations are not as extreme as the unadjusted P/E ratio suggests.
Project Goals:
This multi-part project aims to:
This initial post presents preliminary observations, examines the visual correlation between P/E and M2, and cites the data sources Gemini recommend I use.
Assumptions & Early Observations on CAPE and M2:
As money accumulates among wealthier individuals, a significant portion flows back into the stock market. The top 10% of U.S. wealth holders control 67% of U.S. wealth (as of Q3 2024). It is reasonable that M2 increases have disproportionately benefited this group, further fueling investment in equities.* This concentration of capital seeking returns may contribute to elevated P/E ratios, particularly with bonds in a low-yield environment.
For this analysis, the CAPE ratio is used as the preferred P/E metric due to its use of a 10-year average of inflation-adjusted earnings, which mitigates the impact of short-term earnings volatility. I sourced data from Robert Shiller's website for CAPE and the St. Louis Fed's FRED database for M2 (both linked at the bottom of this post). Each source provides monthly data extending back 50+ years, adjusted for each metric’s current definition. This data is visualized below.
Table 1: 50 Years of Stock Market CAPE Ratios and CAPE/M2