How To Gain Historical Perspective – Part 2

Wednesday, November 11, 2009

Perspective-squares-edit

Yesterday, we saw how using a logarithmic scale can provide a better historical perspective. Today, we take on inflation…

Inflation adjustment is too little done, giving us a false sense of growth and improvement. Even low levels of inflation are an erosion of purchasing power. Inflation rates compound just like investment returns, building up a significant shift over longer periods.

First, take a look at what inflation has done over almost 100 years. The logarithmic scale shows how the rates have changed in different environments. Overall, prices have risen about 22 times since 1910, meaning $10 then and $220 today have equivalent purchasing power. This is an average annual inflation rate of about 3.2%.

CPI LT log

Now let’s see what that means for the stock market. Using the Dow Jones Industrial Average (DJIA), we get an inflation-adjusted (also called, appropriately enough, “real”) value of 464 instead of 10,227.

DJIA LT infl-adj log

Why is this adjustment important? For two reasons: To maintain objectivity when historical results are being used, and to improve our historical perspective. Look especially at the 70s. The reported DJIA was going sideways, bouncing off 1,000 periodically before finally breaking through in 1982. However, adjusted for inflation, this was an extended bear market that finally ended in mid-1982, with the DJIA down significantly in “real” terms. The stock pages were filled with single-digit P/Es and double-digit dividend yields.

So, having adjusted for inflation and plotted the information with a logarithmic scale, we can more accurately judge the “historical” comments we read. Our recent market drop, while serious, hasn’t come close to the bear markets of 1929-1932 and 1972-1982.

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