With the recent Wall Street crash and recovery, how does the Stock Market compare? Where has the stock market really gone over the long run? Or is the upward trend an illusion based on inflation?

Adjusting stock market prices for inflation using the "Consumer Price Index"  is known as the Stock price in "real dollars".

(A "real dollar" is the price after adjusting for inflation).

One of the worst problems with inflation is that distorts our perception... things are not always what they seem and this introduces uncertainty into our decision making process.

Here are some various scenarios:

1. The stock market went up 5% a year and inflation went up 3%.
2. The stock market went up 5% a year and inflation went up 5%.
3. The stock market went up 5% a year and inflation went up 6%.

In example #1 above inflation increased less than the stock market so the real return is 5% minus 3% so you had a "real return" of 2% (before taxes and after the inflation adjustment).

In example #2 inflation increased the same as the stock market so the real return is 5% minus 5% so you broke even (before taxes). But after paying taxes on the phantom gain of 5% you will actually lose money.

In example #3 above inflation increased more than the stock market so the real return is 5% minus 6% so you had a real loss of 1% (before taxes). But you will still have to pay taxes on the 5% gain making your real loss even worse.

As you can see the only way to see the true picture is to look at the inflation adjusted prices.  We have created several other inflation adjusted price charts including Oil, Gold, Corn, Gasoline and Education.

Now, there are many ways to measure the stock market. The one that most people are interested in and commonly mentioned one by the press is the Dow Jones industrials.

I have often wondered why this index is so widely quoted by economic pundits, (other than the fact that it was originally created on May 26, 1896, making it the first index). At the time the DJIA represented the average of twelve stocks from various important American industries. Today the "DOW" is made up of 30 "representative" stocks and it's composition has changed many times over the last 100 plus years.

Rather than rely on "representative" stock indexes I prefer the real thing so I have created this "inflation adjusted stock price" chart by adjusting for inflation on the entire New York Stock Exchange (NYSE). With the largest dollar volume  of any stock exchange in the world and with 2,764 listed securities it gives us a much broader view of the stock market.

Historical Commentary:

Let's look at the stock market and see how it has fared this year in real inflation adjusted dollars compared to previous years.

As you can see from the above chart the blue line shows the "nominal NYSE index" (meaning the actual price quoted by the media). To get the "Inflation Adjusted" red line we adjust the stock price for inflation we used the Consumer Price Index (CPI-U) which is typically referred to as the "Inflation Rate". This gives us the price in terms of modern dollars. In other words, the red line shows what the stock market would like like if there was no such thing as inflation.

In nominal terms (blue line) the NYSE stock index began 1966 just under 500. And by July of 1982 the nominal stock index had increased to 615 after having been even higher. So on the surface it would appear that the "stock market" posted an increase of roughly 23%.  (615-500=115) and (115 ÷ 500=.23)

Now a 23% increase in 16 years would be a nominal increase of 1.43% a year (less if you consider compounding) which doesn't sound that great, but in those days stocks paid higher dividends than they do today. So investors expected to get their profit from dividends rather than capital appreciation. So most investors would be happy with a 23% increase in their stock portfolio over and above their dividends.

The inflation adjusted stock price

However, when you adjust for the increase due to inflation, we can see from the red line (which is the "inflation adjusted NYSE Index stock price" in current dollars) that in inflation adjusted dollars the index began 1966 higher and fell through July of 1982.

So rather than a 23% increase, if you count inflation and had held stocks for the 16 years from 1966 to 1982, you would have actually lost about 59% of your purchasing power due to inflation.

But to make matters worse you would have paid taxes on your dividends and "paper gains" further reducing your final remainder. This may be one reason companies began reducing dividends, so more money was pumped into increasing the stock price.

Inflation affects foreign exchange (forex) markets in much the same way as the stock market.  Forex charts from fxcm.com are useful for tracking forex markets. 

Current Commentary:

In the time since 1982 the stock market has increased both in nominal terms and in inflation adjusted terms. Interestingly in inflation adjusted terms the NYSE stock index is below the peak of 2000.

The August 2000 stock peak occurred at around 6800 in nominal terms or 8851 in June 2011 inflation adjusted terms.

From the bottom in April 2002 the market moved higher until the July 2007 peak which was at 11,040 in inflation adjusted June 2011 dollars. This is a 24.7% increase in seven years from peak to peak or about 3.2% per year (compound interest).

Why Prechter Might Be Right

The market looks very much like a "Head and Shoulders" with the 2000 peak being the left shoulder, the 2007 peak being the head, and the February 2011 peak could very well be the right shoulder. With no real support, from there we could easily see a fall all the way down to the 4000 level. From the bottom in 2009, we also have a 3 wave up which is the proper number for a counter trend rally. Elliott wave's call for 5 waves down if we only have 3 waves up. So we have to hope that after a brief 4th wave correction, we get a strong 5th wave move that takes it above the peak in 2000 and ultimately above the 2007 peak. But at this point, it looks like Robert Prechter could still be right and we are at the beginning of a major downtrend ending around 2016 and making the current economic situation similar to the second wave of the Great Depression.

Our NYSE - ROC (Rate of Change) chart tracks the nominal rate of change in the NYSE and gives an excellent visual presentation of stock market nominal rates of return thus making it easier to determine when you should be in the market and when you should be on the sidelines.