We’re not there yet, but when stocks finally do hit bottom, I expect them to explode right out of the gate and for a new bull market to begin.

The reason that stocks could explode to the upside?

A huge amount of investors’ capital will likely be sitting on the sidelines in cash (as a result of the currently tumultuous investment environment) for those investors to put to work in stocks, as well as in equity mutual funds and ETFs — once they see clear signs that the current economic downturn is coming to an end.

As you can see in the chart below, institutional investors have already accumulated a bundle of cash in money market funds.

Individual investors have also significantly increased their purchases of money market funds over the past few months (and liquidated their stock and bond funds) in response to falling stock and bond prices.

In fact, the liquid assets of mutual funds are currently at their highest level since September 2006.

If the Federal Reserve continues to increase the money supply in its efforts to lower short-term interest rates, I expect the cash held at institutional money market funds to increase further during the months ahead for the following factors, discussed below.

The U.S. money supply is determined, primarily, by Federal Reserve open market transactions. When the Fed chooses to increase the money supply, it does so by purchasing U.S. government bonds (in the open market) from certain institutional investors.

Historically, those institutional investors deposited the proceeds from their sale of bonds to the Fed into cash accounts at commercial banks; hence, the money supply rose. The increased level of deposits at commercial banks enabled banks to increase their loans to businesses and consumers alike, which increased the money supply even further.

However, my research indicates that the institutional investors with whom the Fed executes its open market transactions have recently been depositing the proceeds from its sale of bonds to the Fed into money market accounts, rather than maintaining those funds at commercial banks.

I expect those institutions to continue investing the proceeds of their government bond sales into money market accounts during the next few months because institutional investors are well aware that the potential returns that could be generated by investing those proceeds in the equity and bond markets, or by loaning those funds to businesses, don’t justify the risk of loss.

As you can see in the chart below, the monetary base — currency in the hands of the public plus commercial bank deposits at the Federal Reserve — has declined since November 2007 even though the Fed has significantly increased its purchases of U.S. Government Bonds. (Note: Borrower defaults on loans have been partially responsible for the recent decline in the monetary base).

Meanwhile, the growth in the M2 money supply has slowed considerably over the past few months. Yet, the MZM money supply has continued to expand at a rapid rate, primarily as a result of significant increases in institutional money market funds. See the chart below.

M2 Money Supply

Currency held by the public plus travelers' checks, bank savings accounts less than $100,000, checking account balances, balances held at credit unions, and money market mutual funds held by individual investors.

MZM Money Supply

M2 less small-denomination savings accounts, plus institutional money market accounts

At the time of this writing, a preponderance of economic statistics suggest that economic growth in the U.S. will continue to slow over the coming months and that stock prices in general will continue to trend lower.

However, my investment models indicate that stocks may bottom by June. If you’d like to be informed of when my models give a “buy” signal and how to profit from the coming bull market by investing in exchange-traded funds (“ETFs”), click here now