There is a very significant correlation between the money supply, deflated for changes in the consumer price index, and the general level of stock prices. Although emphasis on the importance of liquidity to the stock market is not new, past efforts have focused on absolute, rather than deflated, money supply figures.

Whereas increases in the money supply provide liquidity, increases in the consumer price index eat it up. Gyrations in real liquidity are often reflections of gyrations in the inflation rate. The money panics in 1970 and 1974 were each preceded by substantial reductions in real liquidity.

When the Fed maintains relatively smooth growth in the money supply despite fluctuations in the inflation rate, the resulting fluctuations in liquidity are transmitted faithfully to the Dow. The large air pockets that the Dow encountered in 1966, 1969-70 and 1973-75 were caused by the money supply expanding less rapidly than prices.

The liquidity supply variable is not the only variable affecting the general market level. Interest rates, earnings and dividends all influence the level of stock prices. Over the last decade, however, the liquidity supply variable appears to have had a powerful effect.