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Inflation Could Keep the Dow From Setting New Record Highs For Decades

Bull markets, particularly long-running bull markets, tend to create a bit of an obsession in the financial media. Call it "index record-itis." It's a disease that causes otherwise rational market participants and analysts to focus on the establishment of new all-time highs by the Dow Jones Industrial Average (DJINDICES: ^DJI  )  and, to a lesser extent, the S&P 500 or the Nasdaq Composite. Every new record is cause for celebration, but as we move further from the last record-breaking day (in both time and price), the hand-wringing intensifies on financial news outlets across television and the Internet.

What's often lost -- but rarely forgotten -- in this situation is the simple fact that many of the Dow's records are only records when we refuse to consider the economic environments in which they're set. A dollar invested into a basket of stocks representing the Dow at the start of 1913 would have grown nearly 200 times larger from by now. However, that investment wouldn't be worth 200 times more, because thanks to inflation, the value of that dollar has declined by over 95%, to the point where its purchasing power is equal to about $0.04 today:

US Consumer Price Index: Purchasing Power Of the Consumer Dollar Chart

US Consumer Price Index: Purchasing Power Of the Consumer Dollar data by YCharts.

So what does that mean for the Dow's long-term growth trajectory? For starters, factoring the impact of inflation into the legendary bull market of the Roaring 20s and the Great Depression that followed makes the whole post-bubble period look far worse for investors than it did on its own:

Source: St. Louis Fed. Adjusted by purchasing power from 1913.

It's generally said that the Dow surpassed its 1929 high in 1954, while the S&P (a 90-stock index until 1957) had broken through to new highs several months earlier. However, you can see that it takes the inflation-adjusted Dow a fair bit longer to get back to even with 1929 -- and this chart doesn't even show the whole picture. The Dow's 1929 peak was so overwhelming, and post-war inflation moved so much more rapidly (particularly following Nixon's abrogation of the Bretton Woods Agreement), that the index would spend decades more beneath its inflation-adjusted Roaring 20s peak before finally breaking through to new highs for good:

Source: St. Louis Fed. Adjusted by purchasing power from 1913.

Why start with 1913 and not, say, 1993? The answer is simple: When many people talk about the impact of inflation on our savings or our investments, they frequently overestimate its impact today and underestimate its impact in earlier eras. Imagine riding out an investment that took over six decades to permanently grow more valuable in real terms than it was at the top of a historic bull market. Today's investors don't have anywhere near the same difficulty, since the Dow, even when adjusted for inflation, is actually slightly more valuable now than it was at the end of the last historic bull market:

Source: St. Louis Fed. Adjusted by purchasing power from 1913.

There's another reason to look at 1929 before looking at 2014 -- history shows that a new all-time high, even one adjusted for inflation, is hardly guaranteed to endure, no matter how many years after the old record it arrives. The Dow broke through 1929's real peak to new inflation-adjusted highs in 1959 and fell back. It broke through again in 1962 and fell back a decade later. It broke through again in 1987 only to get smacked back below 1929's real peak by the worst one-day crash in its history.

The Dow is at all-time highs, both nominally and in real terms. It reached that higher level roughly 14 years after the dot-com peak, which is less than half the time it took the index to reclaim 1929's peak in real terms. However, that does not mean the Dow will remain above 2000's highs for the long term. A record, on its own, is meaningless. If investors flee the market, as they once did in droves following the 1929 crash, it won't matter what the economy does, because there won't be enough interest to sustain the sort of durable bull market that broke the Dow through to new highs for good in the 1990s.

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Read/Post Comments (5) | Recommend This Article (2)

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  • Report this Comment On April 24, 2014, at 3:21 AM, Interventizio wrote:

    Very insightful article as always. Makes me think of the dark side of value investing: everybody's talking about the power of time and compounding. That's true. The other truth is though that inflation will eat up much of your gains.

    But what you gonna do?

  • Report this Comment On April 24, 2014, at 9:49 AM, Schneidku40 wrote:

    Better to have gains that are eaten by inflation than no gains and suffer capital loss through inflation.

  • Report this Comment On April 24, 2014, at 11:00 AM, bluedepth wrote:

    Your analyses didn't include dividends.

    Without dividends, comparisons of two points in an index decades apart are largely meaningless.

    For example, from the beginning of 1929 until the end of 1954 the SP was flat in real dollar (inflation adjusted) terms - looks like a horrible period, right?

    But, with dividends reinvested it had annualized gains of 5.3% - not great, but not horrible either. Every dollar invested in the beginning of 1929 would have grown 3.6x by the end of 1954.

  • Report this Comment On April 24, 2014, at 12:02 PM, TMFBiggles wrote:

    @ bluedepth -

    A follow-up article that analyzes the impact of dividend reinvestment was published today, as a matter of fact. You can see the results here:

    It was not my intent to mislead here, only to keep the focus on one issue at a time. Hope the article I've linked gives you the answers you were looking for.

    - Alex

  • Report this Comment On April 24, 2014, at 1:24 PM, bluedepth wrote:

    @ Alex

    Thanks for the link. The new article certainly does show the other side of the coin - what power dividends have over longer time periods.


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Alex Planes

Alex Planes specializes in the deep analysis of tech, energy, and retail companies, with a particular focus on the ways new or proposed technologies can (and will) shape the future. He is also a dedicated student of financial and business history, often drawing on major events from the past to help readers better understand what's happening today and what might happen tomorrow.

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