Has the stock market really gone up? Or is it an illusion
based on inflation?
This 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% - 3% so you had a real return of
2% (before taxes).
In example #2 inflation increased the same as the stock
market so the real return is 5% - 5% so you broke even (before
taxes). But after paying taxes on the phantom gain of 5% you
will lose money.
In example #3 above inflation increased more than the stock
market so the real return is 5% - 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
inflation adjusted price charts including
Oil,
Gold,
Corn,
Gasoline
and
Education.
Today I'd like to take a look at the stock market and
see how it has fared in real inflation adjusted dollars.
Now, there are many ways to measure the stock market. The most
commonly mentioned one by the press is the Dow Jones
industrials.
I have often wondered why this index is so widely quoted, (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.
As you can see from the chart, (above right) the blue line
shows the "nominal NYSE index" . To adjust the stock price
for inflation we used the Consumer Price Index (CPI-U) which is
typically referred to as the "Inflation Rate".
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"
increased by roughly 23%.
(615-500=115) and (115 ÷
500=.23)
Now a 23% increase in 16 years 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 take inflation into consideration, we can
see from the red line (which is the "inflation adjusted NYSE
Index stock price" in current dollars) that in inflation
adjusted 2007 dollars the index began 1966 just above 3200 and
fell to 1312 in July of 1982.
So rather than a 23% increase, if you had held stocks for the
16 years from 1966 to 1982, you would have actually lost
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.
In the time since 1982 the stock market has increased both in
nominal terms and in inflation adjusted terms. Interestingly
even in inflation adjusted terms the NYSE stock index is above
the peak of 2000.
Although the percentage amount of increase above the
2000 peak is much less in inflation adjusted terms than in
nominal terms.
The August 2000 stock peak in nominal terms occurred at
around 6800 while it is 8235 in inflation adjusted terms. So in
nominal terms we have a 35% increase in stock prices since 2000,
but in real terms we only have a 12.8% increase or about 1.8% a
year.
From the August 2000 peak the market moved up to the July
2007 which was 10,273 in December 2007 dollars. Which is a 24.7%
increase in seven years or about 3.5% per year.
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. You can see it
here.