The actual returns that is inflated adjusted is vastly different from what it appears to be. Generally inflation affects the investment returns significantly.
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analysts rejoiced at the Dow Jones Industrial Average's record close on Tuesday. Economists were unimpressed.
Seen from the perspective of the dismal science, the Dow's close isn't a record at all. That is because economists adjust share-price movements for inflation, a factor stock analysts prefer to ignore. Once inflation is factored in, the Dow's stellar run over the past few years looks more pedestrian and the investors who have ridden its wave less wealthy. With consumer-price increases removed, something students learn about in Economics 101, the Dow Jones Industrial Average is far from a record: It hasn't been in real record territory in more than 13 years.
The last nominal Dow record, in October 2007, wasn't a record at all once inflation is removed. The last real, or inflation-adjusted, record was on Jan. 14, 2000.
It is something that analysts and investors should take more seriously, said Richard Sylla, a professor of financial history at New York University's Stern School of Business. "People could be fooled if they don't pay attention to inflation," he said.
The Dow's close doesn't look anything like a record after the economists get through with it. E.S. Browning joins The News Hub to explain why economists insist on adjusting for something stock analysts generally ignore: inflation. Photo: Getty Images.
The effects of inflation are relatively small over the short term. But over a longer period, the distortions can be significant. Ignoring inflation, Mr. Sylla said, the Dow appears to be roughly 140 times its level of 100 years ago, an enormous gain. But removing price increases and counting only real gains, the Dow is roughly seven times its level of 100 years ago, a good gain but far from what it appears.
Even over the past 13 years, a period that is important to many ordinary investors, the difference is significant. In nominal terms, the Dow today appears to have risen 22% from the record it hit in January 2000. But taking inflation into account, it still is more than 10% below that record.
For investors planning for retirement, ignoring inflation can mean overstating the value of future investments and understating the amount of money that will be needed. That can be even more the case for bonds than for stocks, Mr. Sylla said, because the interest payments that investors receive from bonds don't change as prices rise. The longer the bond's maturity, the more inflation eats into the bond's return.
Because most ordinary people are investing now to cover future needs, it also is essential to take into account likely future inflation, which will eat into the real value of future returns, he said.
"You could be fooled if you get a 10% return on your investment. But if prices go up 10%, you won't be any better off," even though you appear to have a big gain, he said.
Wall Street hates this reality. On Tuesday, the Dow closed at 14253.77. That surpassed the nominal 2007 record of 14164.53 and eclipsed the high of 11722.98 hit in 2000.
But since the end of 1994, when the 1990s stock boom began, consumer prices have risen 55% according to the Bureau of Labor Statistics. To see how much stock prices are up in real terms, analysts need to remove that inflation.
Measuring everything in 1994 dollars reduces the gains and makes the Dow chart less exciting, but as economists like to put it, the numbers are real. Tuesday's close is just 9256.38 once inflation is removed. That doesn't even match the inflation-adjusted high of 10194.80 hit in 2007. And it is far from the real record of 10424.28 hit Jan. 14, 2000, according to calculations by Bespoke Investment Group. In inflation-adjusted terms, the Dow still has more than doubled since 1994, but it shows no progress at all since the first part of 1999.
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To reach a real, inflation-adjusted record by this measure, the Dow would need to hit 16052.22 in today's nominal terms, up 13% from Tuesday's close.
Economists at Wall Street firms are aware of the importance of inflation, of course. Some maintain that removing inflation makes stock gains look milder and suggests stocks have more room to rise because inflation-adjusted gains are smaller compared with other economic indicators.
"Our view has been, and continues to be, that the market will likely make a succession of new nominal, and eventually new real, all-time highs as the recovery unfolds over the next few years," wrote chief economist Michael Darda of brokerage firm MKM Partners in a report to clients on Tuesday. Few independent economists make this argument; they simply point out that inflation adjustment provides a more realistic measure of an investor's real returns.
Some economists and analysts said it is important to add dividends and subtract taxes when measuring the Dow's gains. Counting dividends would increase the Dow's gains, while removing taxes would reduce them. Counting dividends and taxes requires assumptions about reinvesting dividends and about whether the account is taxable. Even with most measures of dividends and taxes, however, the inflation-adjusted Dow still isn't back to its 2000 record.
Why don't stock analysts, or the media, account for inflation in calculating stock gains as economists do?
First, it is complicated. The Dow was invented in 1896 to be calculated quickly by hand. Inflation adjustment wasn't practical.Today, with computers, inflation adjustment wouldn't be hard technically, but it would require rethinking decades of history and practice. Experts disagree on methodologies and on which measure of inflation is best. The whole idea confuses a lot of people.
One other thing: Inflation adjustment makes current stock values appear much lower, something Wall Street never likes to do. But looking at an inflation-adjusted Dow chart is a useful reality check.
