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We see many articles and studies that use long-term results to make a point – especially now because the stock market is selling at levels first seen some years ago.

For example, the excitement of the Dow Jones Industrial Average (DJIA) re-crossing 10,000 and the “lost decade,” so-called because markets are at levels first reached about 1999.

However, such analysis can be misleading because inflation, even when it is low, adds up over time.

Long-term investment analysis is important because it allows gaining a perspective of expected risk and return. It can also provide an understanding of relationships between prices and fundamentals and between different types of investments.

In all such studies, inflation must be accounted for. Investment prices are quoted in a currency – here, in the US dollar. While everyone expects that the price of bread today is higher because of inflation, past investment values are seldom adjusted for it. Rather, rates of return are calculated from unadjusted prices. Then the returns are compared to inflation, seeking to determine the “real” (non-inflation) performance of an investment.

Another way is to adjust the investment prices first, then calculate the “real” returns. For example, the following graph shows the DJIA as reported, and then adjusted to 1989 dollars (using the Consumer Price Index – CPI). Although inflation averaged only about 2-3/4% per year for the 20 years, the cumulative effect was that the 2009 dollar was worth only a bit more than 58 cents, compared to a 1989 dollar.

That’s why the DJIA is only about 5,800 in those dollars.

Note that, based on the inflation-adjusted DJIA, the lost decade grows by 20% – to 12 years from 1997. The question is, do today’s prices equate to 1997’s in value terms? This is a key question because it helps determine the desirability – or not – of owning stocks today. I will be addressing that question in subsequent write-ups.

Disclosure: No positions

Source: DJIA, Inflation-Adjusted