• The real money supply leads output by about six months.

• The nominal money supply leads prices by about two years.

• Markets do better when real money is growing faster than output.

The first two stem from the empirical work of Friedman and Schwarz – see also here – while the third is a monetarist market rule-of-thumb, based on the idea that faster growth of real money than output implies “excess” liquidity available to push up asset prices.

These simple rules have outperformed consensus predictions over the last year, continuing a longer-run record of success.

The first rule was the basis for a forecast here last autumn that global economic momentum would pick up into early 2012, in contrast to consensus worries of a US “double dip” and Eurozone implosion.

The second rule was used last spring to predict a peak in G7 inflation in autumn 2011 followed by a modest decline in 2012, a forecast that also appears on track.

The third rule forms the basis for an investment strategy discussed here previously, involving switching between equities and cash depending on whether the annual growth rate of G7 real narrow money is greater or less than that of industrial output. A conservative form of the strategy buys equities six months after a positive real money / output cross-over but sells immediately on a reversal.

The chart compares the historical return on this strategy relative to US dollar cash with that of buying and holding equities. The strategy has beaten buy-and-hold by an average of 3.7 percentage points per annum over the 42 years since 1969.

The strategy outperformed again in 2011, staying in cash during the first nine months of the year before switching into equities in time for a fourth quarter rally. It returned 7.6% more than cash for the year versus a 5.3% loss for buy-and-hold.

The three rules currently suggest that 1) the global economy will expand respectably during the first half of 2012, 2) inflation will trough around the middle of the year and move up into 2013 and 3) equities remain attractive relative to cash. See previous posts here and here re 1) and 2).

Investors are better able to exploit a successful forecasting method when it is not widely employed. The monetarist approach, fortunately, remains deeply unfashionable with an economics herd obsessed with short-term data watching and dissecting the pronouncements of clueless policy-makers.

The six similar bear markets can be used to “benchmark” recent Dow performance. First, the peak of the Dow before each bear was aligned with the October 2007 high and subsequent levels calculated. An average of the six levels was then taken at each date – this “six-bear average” shows a hypothetical path for the Dow based on mean experience after prior peaks.

Secondly, the trough of the Dow after each bear was aligned with the March 2009 low and subsequent levels calculated. An average of these six levels shows a hypothetical path for the Dow based on mean experience after prior troughs – a “six-recovery average”.

The chart compares the Dow’s performance with these two averages. Though derived independently, the averages trace out similar paths after late 2009. The Dow fluctuated above and below the averages during 2010 and 2011. These over- and undershoots correlate with changes in monetary conditions caused by the Fed starting and stopping QE operations, with ECB policy apparently also an influence recently.

For example, the fall in the Dow below the averages in mid 2010 followed the end of QE1 securities purchases in March. The launch of QE2 later in the year, however, was associated with a renewed surge, pushing the index to a significant overshoot by early 2011. Another correction occurred after QE2 ended in June last year, with weakness exacerbated by wrangling over the federal debt ceiling and Eurozone sovereign debt woes. This sell-off reversed following a series of Fed and ECB actions in late 2011, including the initiation of “operation twist” in September, the ECB’s reintroduction of one-year repos in October, an injection of dollar liquidity via Fed swaps with other central banks in November and the ECB’s extension of subsidised lending to three years against looser collateral requirements in December.

The Dow is now further above the averages than in early 2011 but strength is probably warranted by extraordinarily loose global monetary conditions, as evidenced by a large gap between G7 real narrow money and industrial output expansion and record G7 bank reserves. Investors, however, should be prepared for continued volatility: another wrenching correction is likely when monetary conditions tighten, either because central banks dial back on stimulus or stronger economies divert liquidity away from markets – a possible scenario for later in 2012.

The more hostile policy environment for banks in the UK than in Euroland has been reflected in a continued grind higher in the sterling three-month LIBOR / OIS spread even as the equivalent euro spread has fallen sharply – see first chart. This divergence has been reflected in UK bank stocks recently underperforming their Eurozone equivalents, following a large relative gain last year – second chart.

The revision is of questionable value. The Conference Board claims that the new index is a more accurate predictor of business cycles since 1990 but its earlier performance is inferior – as the chart shows, it failed to turn down before the 1960-61 recession, in contrast to its predecessor.

An important change is the replacement since 1990 of the real M2 money supply with a new “leading credit index”. This partly explains why the new index weakened last summer while the old version continued to rise. This weakness, however, appears to have been a false signal, based on recent solid US economic data. Had the new index been in operation, in other words, it would have encouraged dubious recession calls.

The view of this journal, of course, is that real money is a key forecasting tool and should be included in a composite leading index, although in most countries a narrow measure outperforms M2 and broader aggregates.

Recession-mongers will probably claim that the new index is consistent with their forecast since, despite the recent recovery, it has yet to regain the July 2011 peak. They can also argue, with some justification, that the index remains biased upwards by its inclusion of the 10-year Treasury yield / federal funds rate spread – the assumed positive implication of a steep yield curve is questionable when official interest rates are close to zero*. (The view here is that this bias is counterbalanced currently by a downward distortion from the omission of real money.)

* The economy entered a recession in 1937 with a similar Treasury yield curve to currently.