Investing In Stocks: "The Rule of Three"

This essential guide helps investors know when to enter the stock market or invest in stocks.

The Rule of Three

This article features a fundamental indicator that investors can use to understand when it’s a prime opportunity to enter the market or invest in stocks.

The ‘Rule of Three’ indicator is based on seventy years of statistics, and it has seldom failed to forecast money trends.

The indicators are predicated on a straightforward relationship: we compare the current trend in money supply growth with past levels that have typically supported long-term stock rallies. This simplicity should reassure investors that investing in stocks is more manageable than it may appear.

First, let’s explain briefly how money is measured. Just as people who work on a river use various yardsticks to gauge the river’s flow, economists use several measurements to calculate the money supply. The two most common are called M1 and M2.

M1 includes all cash in circulation (like the money in your wallet) and the money in your checking account. M2 includes savings accounts and money market funds in addition to M1. Two other measures, M3 and L, include all of M2 plus such obscure items as repurchase agreements and overnight transfers of $1 million or more between banks.

In general, the Ms tend to mirror one another, but there are some subtle, significant differences. M2 is more inclusive than M1. Though its components are spendable, some are less likely to be spent than the components of M1. This means that M1 is more likely to find its way into the economic river faster than M2.

We have found that gauging changes in M1 is the best way to predict inflation. M2 is more important when it comes to predicting real growth. Thus, when we expect changes in the stock market, M1 is more important. However, when it comes to predicting economic growth, M2 is more important.

The indicators that follow are based on M2. However, they would only have to be varied slightly to work for M1. Moreover, M1 works better than M2 when combining money supply with other variables for an overall market model. But again, the differences are minor; in general, what you say about one holds for the other.

Fortunately, finding money supply figures is a relatively simple matter. Each week, the Federal Reserve compiles more money supply data in its “Money Stock” Statistical Release than you’ll ever possibly need. Each report lists twenty-four months of data on all the various M-money supply measures, including up-to-date figures for the most recent period. Figures for the previous month are typically released mid-month.

Depression Gauge

The first indicator, the ‘Rule of Three,’ tells you when the money supply is shrinking, i.e., when the river is drying up. If it is, it may be time to bail out of stocks in a big way- depression and a catastrophic drop in stocks could be on the horizon. Let’s see how it works regarding investing in stocks.

First, we find monthly M2 and M1 money supply figures for each of the past eight months from the Federal Reserve Statistical Release.

Here’s a model example of historical data that we will present:

If it’s July 1993, we find figures for each month from November 1992 through June 1993.

Next, we add the monthly M2 money supply figures for April, May, and June—the most recent three-month period—and divide by three to get an average.

Then, we do the same thing for January, February, and March, the three months immediately before the most recent one. The money supply is shrinking if the April through June average is less than the January through March average. The ‘Rule of Three’ would flash red in this “model” scenario. This would be a negative indicator.

To discover if the second part of the signal is also red, we compare the average monthly money supply from March through May 1993 with that of December 1992 through February 1993. If the March through May period had an average M2 of $2.1 trillion and the December through February period was $2.2 trillion, for example, the money supply was shrinking. The second part of the Rule of Three would also be flashing red.

Finally, we compare the last three months, from February through April, with the calculated data of November 1992 through January 1993. If the average M2 of February through April is less than that of November through January, the third part of the ‘Rule of Three’ is also a negative indicator. We then perform the same calculation for M1. A red signal is triggered if it’s been negative for three months.

Once a red signal is triggered, a green will occur only when the most recent three months gave a higher average M2 than the previous three months for three consecutive months. And so forth.

Money Supply Signals

A warning from the ‘Rule of Three’ doesn’t guarantee a major recession or depression. But this critical signpost doesn’t often speak. When it does, history has shown that stocks are a disaster waiting to happen.

Historically, from 1922 to 1949, the ‘Rule of Three’ gave a red light five times. Had you sold each of those times and bought back stocks when the rule flashed a green light, you would have rolled up a compounded gain (excluding dividends)!

Look at the two sell signals in May 1929 and February 1930. They suggest that the Great Depression didn’t begin with the Crash of 1929. Instead, it started when the money supply started shrinking in 1930.

Indeed, had the Fed tried to increase the money supply in 1930, the 1929 crash would have been remembered much like the 1962 and 1987 crashes- as just a correction in a long-term bull market.

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