Money velocity is an important concept in economics and finance that is poorly understood outside of both fields. This is unfortunate, because the trend of money velocity is arguably one of the most important trends when considering the optimal monetary policy for a sovereign nation. It is also an important issue when considering long term investment goals and asset allocation strategies.
So what is money velocity? Wikipedia does a good job of explaining the idea, describing it as “how fast money passes from one holder to the next.” In other words, money velocity measures the rate at which there are transactions between individuals within an economic system. Money velocity then will measure how often people will exchange money for goods and services, and trends in the money velocity can often be measured to assess how often a dollar is likely to be used in any given period of time.
One way to think about money velocity is to imagine two people in a room with a single dollar. One person holds the dollar and then agrees to give it to the other person in exchange for something (whatever that thing is doesn’t really matter). Then person 2, after getting the dollar, decides to give the dollar back to person 1 in exchange for another thing. The speed at which they exchange that dollar for something is the velocity of money.
This is a simplified definition, but will do for our current purposes. The key in the example above is the following question: what would make our two people in this economic system decide to exchange dollars faster or slower?
Imagining that same room, let’s also imagine that there is a huge pile of dollars in the room with the two people and that neither owns that pile of dollars. Will they swap that dollar faster or slower, since there are many other dollars in the room? Probably—since the pile of dollars indicates that the dollar they have is of limited value.
Or it might cause they to swap the dollar much more slowly, if they realize that the dollar has too little value and then is not worth receiving in exchange for the thing the other person is asking for. This is a lack of confidence, and happens in market systems frequently. This is what economists call a liquidity trap.
Again, economists might argue for or against the validity of these two models, but let’s assume they are reasonable guidelines for predicting how market participants will behave in each circumstance. In the first case, the implications for equities and for different sectors is very different than in the second case. A market in which market participants are happy to keep the money flowing will have a higher total demand for goods and services—there is more activity, thus more demand for stuff. This is good for the market as a whole (SPY), but also particularly good for consumer discretionary stocks (XLY) because people are choosing more transactions—and thus choosing more discretionary purchases.
In the second case, the lack of confidence will hurt consumer discretionary stocks while favoring consume staples (KXI, XLP). This is because staples are the kind of things people must buy instead of things people choose to buy, and will be thus more insulated from a lack of confidence.
The concept of money velocity is somewhat esoteric, so why should market participants, particularly investors, be aware of the idea and consider it when buying (or not) stocks? Money velocity has had a very clear—and negative—trend for the last 10 years:
The impact of declining money velocity is debatable, but the fact is not; and its importance has been hotly contested by academics. Nonetheless, economists agree that, for whatever reason, people are trading currency for goods and services much less frequently than they used to. Why? Is this emblematic of a lack of confidence? Is it driven by something else? Also note the sharp downturn at the beginning of the Global Financial Crisis—the relationship to negative money velocity growth and depressive macroeconomic conditions existed then. Does it still exist now, when money velocity is even lower than in 2008?
Bulls are quick to point out that consumer discretionary stocks, as well as tech stocks and many other industries, have seen a bull market in recent years as the money velocity has gone down. Bears suggest that this could be the result of QE driving equity returns and not the sign of a resurgent bull market.
If the bears are right, the understanding of MV and equity valuations is essential, because the QE party ended in 2014 and we’re beginning to enter a cycle of tightening that should also cause money velocity to slow further. If that happens, what will happen to the economy—and to stocks?