The Pipe Dream of Dow Highs

If you follow the markets, you can't have missed the furor that has accompanied the Dow's new record highs over the last couple of weeks. The clamor is still growing as we near "Dow 12,000." But what if I were to tell you that these new highs are an illusion -- that the index actually sits 15% below its January 2000 high? Perhaps you'd simply point to the numbers (see table) and object -- surely, I must able to compare two five-digit numbers:

DJIA Closing Value

Oct. 16, 2006

11,981

Jan. 14, 2000

11,723

Get real (forget nominal)!
That objection is true enough, as far as it goes, but it doesn't account for inflation. In the intervening period, what happened to the value of a dollar? Does it have the same purchasing power now that it did at the beginning of 2000, or did it give up some of its value to increasing prices? Even in a stable price environment, such as the one we have experienced since 2000, inflation's bite over a six-year period is far from insignificant. Investors must be aware of this, since their first goal should be to preserve the purchasing power of their capital. (Well, second goal, really, since avoiding capital losses comes before beating inflation.)

If that's not clear, imagine that you have not had a pay raise in the last six years. Would you consider that you are as well-off economically as you were six years ago? If that were the case, you could always try walking into a local business and demanding to pay year-2000 prices for all the goods or services you want to purchase. I can't guarantee the success of that approach.

Let's let the numbers speak for themselves. If we use the CPI to track inflation, and set January 2000 as our base period, the adjusted value for yesterday's "record" closing Dow value is 9,920, more than 15% below its January 2000 value. (See table for calculations.)

Dow
Closing Value

CPI-U

1 / Deflator
(Base: Jan. 2000)

Dow Inflation-
Adjusted Value

Oct. 16, 2006

11,981

203.9*

168.8 / 203.9 = 0.828

11,981 * .828 = 9,920

Jan. 14, 2000

11,723

168.8*

1.000

11,723

* January 2000
** August 2006 (most recent value)

Fixating on new index highs (particularly the Dow, for the reasons I outlined in an earlier article) will distract you from thinking about things that really make a difference in investing performance. If you want to outpace inflation and achieve attractive long-term returns, I'd suggest the following:

  • Have some exposure to equities, since this asset class is most likely to achieve positive real (i.e. after inflation) returns over extended periods of time;

  • In terms of individual stocks, companies that are able to pass on cost increases to their customers can usually offer some protection against inflation. Firms that display this ability may have strong brands, including those of consumer goods giant Procter & Gamble (NYSE: PG  ) or rival and Inside Value pick Colgate-Palmolive (NYSE: CL  ) . Alternatively, they may operate in an industry in which a small number of competing firms serve a fragmented customer base with limited bargaining power. This is the case of MasterCard (NYSE: MA  ) and Moody's (NYSE: MCO  ) . As always, paying a reasonable price for the common shares of such companies is critical to earning adequate returns.

Related Foolishness:

Whether the market is at new highs or lows, stick to the fundamentals! To find out which stocks Motley Fool Inside Value head analyst Philip Durell is currently recommending in his fundamentally sound value-investing newsletter, try a 30-dayfree trialof the service.

Colgate-Palmolive and MasterCard are Inside Value picks. Moody's is a Stock Advisor selection.

Fool contributor Alex Dumortier has a beneficial interest in MasterCard. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.


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