M1, M2, and the U.S. Equity Exchanges

The link between money supply and equity returns is well established.  In the 70s, the focus was establishing a link between the two.  In the 80s and 90s, there were many studies exploring the causality of the link; and during that time there was a conflict of whether changes in the money supply caused changes in stock prices, or whether it was actually the other way around.  Also, in nearly all studies, M1 is usually the measure of money supply used.  The authors, however, suggest there is a gap in the literature related to M2's predictive power, and they explore this relationship as well as settle the causality issue.

The authors use the S&P500, Dow Jones Industrial Average, Nasdaq, and Wilshire 5000 as the equity components, and the M1 and M2 as money supply measures over the period January 1984 to November 2010.  Their study finds the M1 can cause changes in stock prices, but only over long periods of time; the M2 measure, however, can cause changes in stock prices over very short periods of time, and is shown empirically to be a better predictor stock returns.  The authors also note that the Fed's policy of quantitative easing over the period of their writing is in line with these findings.

Parhizgari, A. M., & Nguyen, D. (2011). M1, M2, and the U.S. Equity Exchanges. Frontiers in Finance & Economics, 8(2), 112–135.