Unhedged: Stock prices and the velocity of money

Also bitcoin replies and housing prices

Robert Armstrong


QE and stock prices (part two)

Here are two lines that mostly go up and to the right:


The two lines are the M2 money supply (cash, deposits, money market accounts) and the S&P 500. 

M2 is rising fast because of quantitative easing: the Fed is buying securities for cash, thereby putting new money out there. 

Why the S&P is rising fast is less clear. 

The fact that the two lines have moved together lately encourages a popular causal story: “the Fed is printing money, and it has to go somewhere, and it is going into the stock market.” 

A couple of days ago I noted that these causal stories are wrong, because cash is not transformed into stock. 

When I buy shares, the seller gets the cash. 

It is not “in the stock market”. 

What is really happening is that all the additional money sloshing around makes people want it less, relative to stocks, and the increased relative demand for the stocks forces share prices up.

That’s how QE affects stock prices (or one way it does; other people, especially central bankers, prefer stories about QE lowering the discount rate, on which more shortly.)

Eric Barthalon, global head of capital markets research for Allianz Research, notes that this process is self-limiting. 

As equity prices rise, the weight of cash relative to equities in investors’ portfolios goes down to a level where the investors are happy. 

Investors stop trading so much, and prices stabilise. In this story, it’s not the Fed simply stuffing the markets with cash. 

There is an intermediary factor: investors’ relative preference for cash. 

Barthalon’s argument — I find it pretty convincing — is that (a) investors preference for cash is not stable and (b) the Fed is not in control of it at the moments that matter, that is, when markets are falling. 

You can track investors’ unstable preference for cash by looking at the velocity of money, or how much it changes hands. 

Barthalon told me:

“It is not the quantity of money but its circulation that causes asset prices to rise or fall . . . and historical experience shows us that central banks do not control the velocity of money, especially in capital markets.”

Now we see why central bankers might prefer the notion that with QE, they control the discount rate that determines the value of stocks, by keeping yields on government bonds low. 

Because that lever will, in theory, work even if investors suddenly decide they like cash quite a lot — which they do when markets fall.

Here is Barthalon’s long-term chart of the velocity of money in the stock market (the value of daily market transactions divided by M2) against the value of the stock market. 

Look at how velocity drops hard in market declines:


Those two lines co-vary, and are related by a tidy causal story. 

The takeaway is that the sheer volume of money floating around can’t, by itself, keep the stock market high. 

Dept of Armstrong is wrong: bitcoin

Yesterday I argued that bitcoin is best thought of as equity in a company whose only asset is an unproven technology. 

That technology will be proven when bitcoin becomes money. 

But bitcoin is not money now because, while people trade it, it is not widely accepted as a form of payment, there are few transactions in it, transaction costs are high, and so on.

The most common reply I received was that bitcoin is not trying to be money. 

Money has two key properties. 

It is a store of value and a medium of exchange. 

Most of the people who think I am wrong think bitcoin is all about storing value. 

That is why its finite supply is so important. 

If it’s a bit costly to trade, a bit illiquid, and so on — who cares. 

It is akin to gold and diamonds, commodities whose salient feature is their rarity and how much they are prized, not their ease of use.

I am not convinced. 

Gold and diamonds have uses in industry and jewellery, they have millennia of convention supporting their preciousness. 

The only thing supporting bitcoin as a store of value, as a precious commodity, is that it might be both a store of value and an especially good medium of exchange — one that can transact widely, frictionlessly, at a low cost, and (here is the real key) without third-party oversight or government control. 

And I don’t think we yet know that this is so. 

Bitcoin is scarce, but so are the watercolours I painted in high school. 

That does not make them a store of value.

One good read

I was struck by this Bloomberg story about how house demand in the US is so strong that homebuilders are moving away from fixed prices, doing blind auctions to secure the highest possible bids:

“A collision of pandemic-related forces [is] holding back new inventory just when it’s needed most. 

Buyers are stampeding for new homes as remote work upends employment, while soaring lumber costs and a shortage of workers are slowing construction.”

This description suggests there is no toxic 2007-style speculation in the mix. 

That makes me paranoid. 

Isn’t speculation everywhere these days? 

Why not housing? I don’t know if there is any evidence that there is, but I’m going looking. 

If you have any, email me.

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