In a previous report dated May 17, 2004 and entitled "M3 Money Supply: Support of a Different Kind", I discussed the monetary support that the Federal Reserve often lends to a falling stock market. The premise of the article was that as the stock market falls, the rate of change of the M3 money supply increases, and indeed my research showed this to be the case - trends in M3 money supply affect trends in the stock market.

Or to see visually what I am talking about look to figure #1. Here is a weekly chart of the NASDAQ 100 going back to 1990; the bottom graph is relative strength indicator of the M3 money supply (data is hidden), and I have over laid this same indicator on the price chart as well. (This relative strength indicator measures and compares the rate of change of the M3 money supply at various points over the preceding year.) As you can see, the explosive rise in the NASDAQ in the mid to late 1990's coincides with an increasing M3 money supply. As the market topped out in 2000 so did the M3 money supply (blue oval), and since 2002, the indicator has been trending down.

Figure #1/ NASDAQ100 (weekly)/ M3 Money Supply

Ok, that is a big picture look at M3 money supply and the stock market. What about this idea that as the stock market falls the creation of money by the Federal Reserve actually lends support and provides a buffer to falling prices. While I am interested in knowing how the stock market has performed under such circumstances (i.e., falling prices, rising M3), I also want to know what happened to the market when prices actually went lower despite the expansion in the M3 money supply. And that is going to be the gist of today's article because I believe the stock market is at such a juncture. In May the markets sold off, and the M3 money supply increased to all time highs. Yet we haven't seen new highs in prices, and if anything the stock market has not stabilized and appears vulnerable. The question is: how have the markets performed under such failures?

First, let's establish the link, once again, between a falling market and an increasing money supply. The market I will be looking at is the NASDAQ 100 with weekly data going back to 1987. To determine when the market was oversold, I used the penetration of the lower Bollinger Band line by price. (In this case, I set the standard deviation to 1.5). Since 1987, there have been 16 occasions where price penetrated the lower Bollinger Band indicating an oversold condition. During 13 of these oversold conditions, the relative strength indicator, which measures the rate of change of the M3 money supply, increased. What happened to prices during this scenario of a falling stock market and rising M3 money supply?

A simple trading system should illustrate our cause. With the NASDAQ market oversold, an entry was made when the relative strength indicator was either trending higher already or changed direction to begin a new trend higher. The position was sold when price crossed below the 100 day moving average (middle Bollinger Band line) or when after 4 weeks price re-penetrated the lower Bollinger Band line (i.e., the market got oversold and stayed that way for a long time).

There were 13 instances of a falling stock market and a rising M3 money supply. Under the scenario outlined in the above paragraph, there were only 3 losing trades. All three trades were after the year 2000, and all three went for greater than 20 plus percent losses. Of the 10 winning trades, 9 out of these 10 had draw downs of less than 6%. I think evidence like this clearly supports the fact that the Federal Reserve through the manipulation of the M3 money supply buffers the stock markets when needed.

But before we look at the oversold instances that either failed or where not supported by a rising M3 money supply, I want to develop the above idea into a better trading system. So let's wait for the NASDAQ market to become oversold, and when it does, buy the market if the relative strength indicator starts to trend higher. A 6% stop loss is utilized and the position is exited when price crosses below the 100 day moving at a time when the relative strength indicator of the M3 money supply is trending downward. The results are shown in Table #1.

Table 1.

Oversold NASDAQ, Rising M3 Money Supply*
Index	NASDAQ
Time Period Studied	17.25 years
% of Time in Market	45%
# of Trades	14
% Profitable	64%
Annual Rate of Return	39%
Return on Account	1214%
Buy and Hold Return	873%
Select Profit Factor**	7.34
Average Win::Loss	4.08
Rina Index***	150

* does not include commissions or slippage; system results as of July, 2004 and reflect prices on an Index not a cash proxy
** select profit factor is gross profit/ gross loss excluding statistically significant outlier trades
*** the Rina Index combines Select Net Profit, time in the market, and drawdown calculations into a single reward/ risk ratio; greater than 30 is acceptable

With a maximum 6% drawdown against your initial capital per trade and with less than 50% time in the NASDAQ, a simple system such as this would have beat a buy and hold approach handily. To be fair, the maximum draw down is about 18% from the equity curve peak; this was due to 3 losing trades in a row.

Ok that is great, but what I am really after is what happened to the failed signals or the 3 oversold signals that occurred without a rising M3 money supply. You see on May 14, 2004 the above system gave a new signal; a position was initiated (at 1400 $NDX.X) with a 6% stop loss. Since May, the M3 money supply relative strength indicator has turned down as of 2 weeks ago, and although the NASDAQ 100 currently is at 1420, the market appears anything but healthy. So is this going to be a failed signal? And if so, what do other failed signals say about prices to come?

As mentioned above, there were a total of 16 over sold signals. 13 had M3 money supply "support" and 3 did not. Only 1 of these oversold signals (May, 2000) developed into a bounce for a 12% gain. The other two over sold signals continued deeper into over sold territory for loss of minus 17% (August, 1990) and minus 28% (March, 2001) before turning higher.

Being that we are on a signal now, what about the 5 failed trades from our trading system? Once the 6% stop loss was hit, where did prices go from there? In the first instance (November, 1987), prices continued lower for another 7%. The second time was October, 2000 and prices dropped another 39% (beyond the 6% stop loss) before another oversold signal was registered. The last signal is actually 3 losing trades in a row. Prices fell another 38% before a bottom was made in October, 2002.

Interesting 2 of those failed signals were during the mother of all bear markets. Two of the oversold signals without M3 money supply support were also in the bear market. One developed into a 12% gain.

What is the take away message?

Oversold signals in the stock market and a downward trend in the relative strength indicator of the M3 money supply have not been supportive of higher prices. Failed signals -that is, where prices have not gone higher despite M3 money supply support and an oversold condition- generally have led to substantially lower prices. However, it should be noted that 2 of these 3 failed signals occurred during the bear market of a couple years ago.

I guess it is worth pondering if a failed signal at this juncture will mean the resumption of the bear market and if the Federal Reserve has lost its ability to ward off the forces of the bear market.

Only time will tell.

That's The Technical Take!

The Technical Take
$ support from M3 Money Supply is breaking down
$ monetary environment is not favorable to higher prices
$ valuations are neutral
$ sentiment continues to be bearish for stocks
$ price action is neutral at best and appears to breaking down

Thanks for reading and I hope you have found my analysis informative, insightful and profitable....

If you would like more information regarding my methodologies, please contact me at blueguyzee@yahoo.com.