How Bank Lending Predicts The Stock Market

From the outside, it appears that successful investors have an astonishing ability to predict the future. They seem to know how the stock market will move, and they trade just before unexpected (and lucrative) changes take place.

In truth, the world’s best investors don’t have superhuman abilities. What they do have is a keen understanding of what factors influence the market, and they can identify even the smallest, most nuanced fluctuations in critical data points. More importantly, they act before the direction of the market is obvious to a larger audience, putting them in the right place at the right time to build wealth.

Certain economic reports are released through the media with great fanfare, and there is extensive discussion of how the information has impacted or will impact the market. Examples include details on the Gross Domestic Product (GDP), the Consumer Price Index (CPI), which measures inflation, and the unemployment rate. However, by the time these are published, it is too late to get a jump on other investors.

A secret to financial success in the stock market can be found through careful monitoring of less familiar reports. One of the most useful includes expansions and contractions in bank lending. Specifically, investors who understand how bank lending predicts the stock market can make trades with the same precision and timing as top investors.

So, how does it work? How does bank lending predict the stock market?

Is There A Correlation Between Bank Lending And The Stock Market?

From a historical perspective, the stock market can be relied upon to grow over time. Portfolios that reflect the movement of the market as a whole over many years are protected against inflation risk, which is the biggest obstacle to creating long-term wealth.

Of course, the fact that the market will eventually go up doesn’t do much for short-term investors. There are no fool-proof methods for predicting market behavior over the next day, week, month, or year. Anything can happen.

Fortunately, there are strategies to improve the accuracy of predictions. The best is to examine patterns in other data sets to find correlations. When changes in correlated data points occur, chances are high that the market will behave as it has in the past.

A deep dive into the relationship between bank lending activity and stock market trends has shown a meaningful correlation between the two. When bank lending increases, the market goes up. When it decreases, the market goes down. However, it’s not a cause-and-effect situation. The two factors are correlated – they move together based on outside events.

Over the past 50 years (January 1973 – April 2023), the growth in bank loans and leases is enormous – roughly $567.3 billion to $17.3 trillion. That’s an average of approximately seven percent of growth each year, but the growth trajectory wasn’t completely smooth.

In addition to minor accelerations and decelerations in bank lending, which are to be expected, there have been four instances in which lending rates dropped dramatically – 1.5 percent or more. They include:

  • 1975 – 1.9 percent drop

  • 2002 – 2.2 percent drop

  • 2008 – 2010 – 6.9 percent drop

  • 2023 – 1.5 percent drop

After each of the first three substantial contractions in bank lending, the stock market lost a significant portion of its value.

Investors who are monitoring bank lending activity today believe that the reduction in activity occurring now is a sign that the next big market drop is coming soon. If so, now is the time to reassess holdings and restructure portfolios to ensure they can weather the storm.

Why Does Bank Lending Predict The Stock Market?

“Bank lending” is an umbrella term for all of the commercial banking activities that involve extending credit.

Common examples include real estate loans for both commercial and residential properties, credit cards, personal loans, lines of credit, commercial loans, and industrial loans.

Generally speaking, banks are focused on growing their loan portfolios because their biggest profits come from the interest they charge to borrowers. With that in mind, there is good reason to be concerned when bank lending decreases.

When banks are more selective about lending, there is less cash flowing through the economy. It is more difficult for consumers to qualify for the loans they need to make large purchases like homes and cars, and businesses struggle with start-up costs and the expenses associated with expansion, acquisitions, research and development, and staffing.

All of those activities contribute to economic growth, so a decline in bank lending can eventually impact the stock market – but that comes later when a cause-and-effect relationship begins to take hold.

The market often begins its downward trend before the reduction in credit has translated into reduced economic activity, because the factors that prompt banks to tighten qualifications for borrowers are the same factors that create challenging market conditions.

Examples of factors that prompt banks to tighten eligibility criteria for borrowers include rising interest rates and a reduction in the US money supply – both of which are in play today.

In the 14 months ending May 4, 2023, the Federal Reserve’s policy-making committee increased the federal funds rate ten times. It went from 0 percent in early March 2022 to 5.25 percent in early May 2023. This rate influences the interest rates that banks charge each other and their customers.

Meanwhile, the money supply decreased 4.1 percent from March 2022 to March 2023. It’s the first time that the US money supply has gone down in 90 years, and it is one of the largest drops in US history. The combination of these two factors suggests that the US is at risk of deflation, and a recession is likely to follow. As a result, banks are hesitant about lending.

Does that mean a recession is inevitable? No. But is it likely? If historical patterns hold, the answer is yes.

Bank Lending And The Stock Market: The Bottom Line

The bad news is that there is no way to be sure what the stock market will do next. It is inherently unpredictable, even for the best investors in the world. The good news is that the accuracy of predictions can be improved by looking at correlated data.

Every week, the Board of Governors of the Federal Reserve reports on bank lending activity – a figure that has demonstrated a correlation to movements in the stock market.

Right now, bank lending is down, which suggests that the market may experience a substantial decline. It’s time to rethink growth portfolios and consider the implementation of a recession-proof investment strategy.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.