Inflation Adjusted Stock Prices

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.