What is The True Stock Market Price (Inflation Adjusted)?
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:
- The stock market went up 5% a year and inflation went up 3%.
- The stock market went up 5% a year and inflation went up 5%.
- The stock market went up 5% a year and inflation went up 6%.
- The stock market went down 5% a year and inflation went up 2%.
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.
In example #4 you have a 5% loss on the stocks plus a 2% loss of purchasing power for a net loss of 7% but you will be able to offset that somewhat by claiming the loss on your taxes.
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, Electricity, Mortgage Rates and Education.
The most commonly mentioned method to measure the stock market is the Dow Jones Industrial average.
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. Because the Dow takes out poor performing stocks and replaces them with better performing ones it has an inherent upward bias.
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). The NYSE has the largest dollar volume of any stock exchange in the world. It has 2,764 listed securities, so it gives us a much broader view of the stock market than any 12 or 20 or 30 stocks could. With only 30 stocks a large move in any one of them could influence the entire index. There have been days when Microsoft or Wal-Mart alone has created a significant move in the index even if all the other 29 stocks were doing nothing.
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 using 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 look 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 and wasn't taxable until you actually sold.
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 just slightly above the peak of 2000. The August 2000 stock peak occurred at around 6800 in nominal terms or 9118 in April 2013 inflation adjusted terms. So in 13 years the market has gone precisely nowhere. This is why "buy and hold" doesn't work.
From the bottom in April 2002 the market moved higher until the July 2007 peak which was at 11,318 in inflation adjusted 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
In inflation adjusted terms, 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 beginning of the right shoulder. The dotted line from the 2000 peak would be considered the "neckline" and the inflation adjusted price for the right shoulder needs to cross above this line to cancel out this pattern which it appears that we are now in the process of doing. However, now we are in "no man's land" if the NYSE makes new highs (above the inflation adjusted July 2007 peak we can assume it will continue upward for a while. But there is still the possibility that because the 2008 crash was below the 2002 crash that the trend is still downward. (This is only visible in inflation adjusted terms). A move above 11,373 would negate this.
Find out more about how Prechter thinks get his 50-page Independent Investor eBook. It will challenge conventional notions about investing and explain market behaviors that most people consider “inexplicable.”
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.
For more information on the effects of cumulative inflation go to Cumulative Inflation by Decade for a full description.
Inflation Indexed Bonds (i-Bonds) are supposed to protect you from inflation while providing a reasonable return. How well have they done?
See Other Inflation Adjusted Prices: