A warning signal in the economy is telling investors they should load up on defensive stocks, research firm says

• The economy is sending a signal for investors to flock to get defensive, Ned Davis Research said.
• M2 money supply is shrinking, an indicator that's typically favored defensive stocks, strategists said.

The economy has been flashing a warning sign for more than a year — and it's telling investors that they should be paying more attention to a particular area of the stock market, according to Ned Davis Research.

Strategists at the firm pointed to the contraction in the money supply, a measure of how much money is flowing around in markets and the economy.

The economy's stock of M2, one class of the money supply, has been shrinking in real terms since the start of 2022. Historically, that signal has preceded the start of a recession, and has typically indicated an environment in which defensive stocks outperform cyclical stocks, the firm wrote in a report.

The M2 money supply has been distorted since the early days of the pandemic, the firm said. In 2020 and 2021, the Fed grew its balance sheet, which added to the money supply. But the central banks has been trimming their balance sheet since it kicked off its fight against inflation, reducing some of the excess liquidity in markets.

"Stocks have generally performed better when real M2 money supply is rising. Similarly, sector leadership has tended to be more cyclical when y/y growth has been at high levels," the report said. "While the growth rate has been moved higher in 2024, it remains in contraction territory, at levels supporting defensive stock leadership."

That suggests investors should be heading into sectors like utilities, consumer staples, and healthcare, with the latter two sectors being the best-performing when the M2 money supply is running below its long-term average, the strategists added.

Other forecasters on Wall Street 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 2025, pointing to the contraction in M2 as one of the warning signs.

Still, the consensus on Wall Street is that the US economy looks to be on solid footing, with GDP expanding in the third quarter even as inflation continued to cool. Economists see the odds of a recession in the next year at just 33%, according to a third-quarter survey conducted by Bankrate.