Boston Financial Management

The Financial Pages

VOL. VII Issue 1 April 2009

The Velocity of Money

A Necessary, and Currently Lacking Ingredient
in an Economic/Earnings Recovery Scenario
While Money Supply Growth is Booming, and Typically Leads a Revival of
Economic and Earnings Growth, the Velocity of Money is Plunging.
A Reversal in the Velocity of Money is Crucial in Adding Clarity
to the Timing of an Economic and Earnings Upturn
by Charles T. Casazza

Starting with Money Supply. . .

In the past, the expansion and contraction of money (see blue circles on chart below) the economy and
supply have been an excellent leading indicator in earnings growth is at, or near, a trough.
establishing turning points in both the economy
and earnings. When money supply growth turns The good news is that the money supply today in the U.S.
negative (red circles on chart below) economic is booming and has registered one of the highest rates
and earnings growth is at, or near, a peak. On the of growth in decades. As mentioned above, this typically
other hand, when money supply turns positive coincides with both an economic and earnings revival.
The Velocity of Money . . . continued on page 2
Ann% Ann%
Chg Real M1 Chg
12 12
8 8
4 4
0 0
-4 -4
Ann% Ann%
Chg Real GDP Growth Chg
6 6
4 4
?
2 2
Source: BCA Research 2009

0 0
-2 -2
Ann% Ann%
Chg Chg
Nonfinancial Corporate Earnings
20 20

10 ? 10

0 0

1980 1985 1990 1995 2000 2005

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 Page 2 The Financial Pages April 2009
The Velocity of Money . . . continued from page 1 B ANKS A RE H OARDING C ASH
Bil.$ Bil.$
. . . Then, Transitioning to Velocity of Money 800 Excess Bank Reserves 800

However, the bad news is that the direction of 600 600

economic and earnings growth is a not a function of 400 400
the expansion or contraction in money supply alone.
200 200
It is also dependent on how fast the money injected
in the system transacts. In this regard, shown below Bil.$ Bil.$
Bank Cash Assets
is one of the two measures utilized to quantify the

Source: BCA Research 2009

600 600
velocity of money, or the rate of transaction growth. 400 400
Both are trending in a direction not particularly
200 200
conducive to anticipating an economic turnaround.
0 0

The First Measure of the Velocity of Money 2005 2006 2007 2008 2009
The M1 Multiplier 16-Week Change

The Fed has three monetary aggregates. The M1 a partial answer. The banks have built up massive
aggregate includes bank deposits and cash in excess reserves and cash assets.
circulation. The M1 multiplier is the ratio of M1 to
the St. Louis Feds adjusted monetary basea broader Keeping that gargantuan amount of money on their
measure of money supply. As shown below, the M1 balance sheets is the primary culprit in the velocity
multiplier has declined sharply over the past several of money swoon.
months indicating the deceleration in the rate of
In order to provide further perspective, a second chart
transaction growth is offsetting the potential positive
on the top of page 3, illustrates where the money hasnt
impact of the recent rapid money supply growth.
goneand thats to reinvigorate the economy. Total
An obvious question unfolds. Knowing money loans and leases as well as commercial and industrial
supply growth has skyrocketed, Where did all loan growth, which can in fact translate into future
that money growth go? The chart above provides economic growth, continue to falter.

The Disappearing Money Multiplier The Velocity of Money . . . continued on page 3

2.0

1.8

1.6
(Ratio)

1.4

1.2

1.0

0.0
2000 2002 2004 2006 2008 2010
Federal Reserve Bank of St. Louis
Source: Federal Reserve Bank of St. Louis: research. stlouisfed.org
 April 2009 The Financial Pages Page 3
The Velocity of Money . . . continued from page 2

T OTAL L OANS AND L EASES IN B ANK C REDIT AT C OMMERCIAL B ANKS

Percent change from a year ago
20
15
10
5
0
-5
Source: BCA Research 2009

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

C OMMERCIAL AND I NDUSTRIAL L OANS AT C OMMERCIAL B ANKS

Percent change from a year ago
25
20
15
10
5
0
-5
-10
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

The Second Measure of the Velocity of Money
U.S. GDP divided by U.S. Money Supply.
The second measure of the velocity of money
provides an excellent historical perspective given
that the data go back to the 1930s. As shown below,
there have been four periods where this measure has
dropped significantly1929/1932; 1942/1946,
1997/2002, and 2008-to-date (see red arrows).
In each of these four instances significant economic
weakness, as is the case today, ensued. As might be
expected, the truly severe economic experience like
The Great Depression had both money growth
and velocity significantly deteriorating.
Why the Velocity of Money is One of the Key
Stock Market Outlook Factors based on a
Valuation Perspective
Over the past several months, the markets valuation
profile has proven to be a rather disappointing moving
target. The primary reason has come from the earnings
side of the equation. What has undermined the
valuation argument (as well as the stock market) over
this time frame is the substantial decay in earnings
estimates which severely understated the S&P 500
price earnings ratio. Since the end of last year, the
S&P 500 earnings expectations have been navigating
a slippery slope falling in excess of 40% or, from
the mid-$90s to the mid $50s. From a stock market
perspective, for the valuation case to finally add value
The Velocity of Money . . . continued on page 4

Velocity of Money 19282009

Source: Federal Reserve Board: Bureau of Economic Analysis

ANNUAL
2.25 2.25
1997 = 2.12

2.00 2.00

1.75 1.75

1.50 1.50

1.25 1.25
1932 = 1.17 1946 = 1.15
1.00 1.00
1930 1940 1950 1960 1970 1980 1990 2000

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 Page 4 The Financial Pages April 2009
The Velocity of Money . . . continued from page 3

to the investment process it is imperative that earnings estimates, at a minimum, begin to stabilize.
The critical question at this stage of analysis now becomes, How can that happen?

If the velocity of money reverses to a more normal level, money supply growth could clearly have a far
greater stimulative effect on the economy, and particularly earnings, as shown in the chart on page 1.
Then, within a stock market framework, the rapid money growth with a velocity kicker would be coupled
with a better than average stock market valuation profile.

The chart below is a Stock Market valuation framework constructed to have four quadrants based
on two inputsthe stock markets P/E ratio (left axis) and monetary conditions (bottom axis).
The four quadrants are defined as follows:
1. Below median valuation (P/E) and easier than average monetary conditions (the most favorable quadrant)
2. Above median average valuation (P/E) and easier than average monetary conditions
3. Above median valuation (P/E) and tighter than average monetary conditions (the least favorable quadrant)
4. Below median valuation (P/E) and tighter than average monetary conditions

Combinations of Valuation and Monetary Conditions (19602009)

0.0
Below-median P/E and tighter-than-average Below-median P/E and easier-than-average
monetary conditions monetary conditions
5.0

10.0
QUADRANT 4 QUADRANT 1
Q4-2008
P/E Ratio

15.0

Source: BCA Research 2009

20.0
QUADRANT 3 QUADRANT 2
25.0

30.0
Above-median P/E and tighter-than-average Above-median P/E and easier-than-average
monetary conditions monetary conditions
35.0
-3.00 -2.00 -1.00 0.00 1.00 2.00 3.00 4.00 5.00
Monetary Indicator

The current reading (circled in red above) is in the top right quadrant which represents the most favorable
combination of the variables.

Given the almost 50 years of quarterly data, future real equity returns over a 1 and 3 year basis were
the highest when in this quadrant. As one might expect, though, the risk inherent in this analysis is
the accuracy of the inputs. Without a velocity of money upturn, further downside earnings estimate
deterioration is likely to continue and keep the valuation argument for the stock market on that above
mentioned slippery slope.

Richard H. Morse, Chairman Mark E. Ingram, CFA, Vice President Kristina A. Erasmus, Client Services Administrator
Michael L. Brown, JD, CPA, President and CEO Geoffry A. Juviler, CTFA,Vice President Lawman F. Johnson, III, Operations Administrator
Thomas C. Abisalih, Managing Director Alan T. Macdonald, CFA, Vice President Jonathan D. Lynch, Client Services Administrator
Charles T. Casazza, Managing Director Janell Phillips, CFA, Vice President Douglas J. Snook, Client Services Administrator
John S. Goldthwait, Managing Director Carol A. Cusson, Controller Jayme M. Metzler, Administrative Coordinator
Susan G. Zimmerman, Managing Director Richard T. Morse, Jr. Portfolio Manager/Equity Trader
Karen R. Bottar, Ph.D., Vice President Lee McNeil Read, CTFA, Director of Client Services