The Supply of Money and Common Stock Prices

The authors begin by suggesting a theoretical explanation for why changes in money supply and common stocks may be related.  They review the Dividend Discount Model, noting that investors would value a stock based on the rate and growth of dividends, the risk free rate, and an equity risk premium.  Their study attempts to show that changes in the money supply are positively related to the rate and growth of dividends (which increase a stock's value), and negatively related to the risk free rate and equity risk premium (which decrease a stock's value).  The authors suggest that a decrease in the money supply will cause an increase in interest rates, which would cause a decrease in expenditures, which will decrease sales, which will ultimately decrease profits and dividends.

The authors study the period January 1954 - April 1969 using the S&P 500 and M1.  They develop a regression equation that produces an R^2 of 0.968, but note a significant amount of serial correlation.  They then use a series of regressions to forecast 1-month ahead out-of-sample (1960-1969) stock prices based on money supply changes; in doing so, their regressions explain approximately 90% of the error, meaning a very good fit.

The authors then used a regression equation using factors of unemployment rate, inflation rate, and level of the US international reserve position in order to predict the growth in money supply, under the assumption that the Federal Reserve would makes its decisions based on the levels of these factors.  They find their regression reasonably explains the growth rate of money supply, but note that the errors may stem from the Federal Reserve's changes in policy throughout different regimes during the sample period.

The authors then use simulations to test the level of stock price forecasting regression under normal investment decision making conditions.  They give an investor 2 options to invest in: S&P 500 or 3-month treasury bills.  Based on the prediction of the regression equation, the investor chooses to go all-in on stocks or treasuries.  There are 6 simulations performed; 3 with margin and 3 without; and the 3 assuming perfect foresight, naive extrapolation, or regression prediction of the money supply variables that go into the regression equation. 

The results of the market test show that an investor could have used this regression to beat a buy-and hold strategy by 2% CAY on return and slightly reduce risk; although, this could have only been done by reasonably predicting (either through perfect foresight or regression) the money supply variables that go into the regression equation.  Naive extrapolation of the money supply variable underperformed the buy-and-hold strategy.

HOMA, K. E., & JAFFEE, D. M. (1971). The Supply of Money and Common Stock Prices. Journal of Finance, 26(5), 1045–1066.