• The economy is sending a signal to investors to rally on the defensive, Ned Davis Research said.

• The M2 money supply is falling, an indicator that generally favors defensive stocks, according to strategists.

• Investors should look to sectors such as healthcare and consumer staples, they said.

The economy has been sounding warning bells for more than a year — and it’s telling investors they should pay more attention to one particular area of ​​the stock market, according to Ned Davis Research.

The company’s strategists pointed to the contraction in the money supply, a measure of the amount of money circulating in markets and the economy.

The stock of M2, a category of money supply, has been declining in real terms since the start of 2022. Historically, this signal has preceded the start of a recession and has generally indicated an environment in which defensive stocks outperform cyclical stocks. , the company wrote in a report.

The M2 money supply has been distorted since the early days of the pandemic, the company said. In 2020 and 2021, the Fed expanded its balance sheet, which increased the money supply. But central banks have been reduce their balance sheet since it launched its fight against inflation, reducing part of the excess liquidity on the markets.

“Stocks have generally performed better when the real money supply M2 increases. Likewise, sector leadership has tended to be more cyclical when annual growth has been at high levels,” the report said. “Although the growth rate has increased in 2024, it remains in contraction territory, at levels supporting defensive stock market leadership“.

This suggests that investors should look to sectors such as utilities, consumer staples and healthcare, with the latter two sectors being the most efficient when the M2 money supply is below its long-term average, the strategists added.

Other Wall Street forecasters have pointed to the contraction in the money supply as a potential omen for the economy. Steve Hanke, a Johns Hopkins economist, recently predicted a recession by early 2025pointing to M2 contraction as one of the warning signs.

Nonetheless, the consensus on Wall Street is that the U.S. economy appears to be on solid footing, with GDP growing in the third quarter even as inflation continues to ease. Economists see the chances of a recession next year at only 33%according to a third-quarter survey conducted by Bankrate.

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