Thursday, May 29, 2008

The Power of Inflation on the DOW

Happy Thursday to all!

I have talked a lot about inflation recently, and I wanted share a couple of interesting graphs that I picked up from Itulip.com.



The author of this graph(who was not named) has done some sophisticated calculations on the real return on the DOW since 1924. Including inflation, the DOW has historically returned 1.64%. How bad is that!! Wall St. doesn't like to include inflation when they brag about their outrageous returns over the years when they are talking you into buying stocks.

If you look at history, for ever great run that the pigmen have had of 15-20% type returns, there is a downturn where they get creamed. A good example of this is the 50% drubbing they took on the S&P during the dotcom bust. When all of these deviations from the mean get averaged out including inflation 1.64% is not too impressive is it?

Now what I want you to focus on here is the returns during the last prolonged period of inflation in the 1970's. As you can see the DOW performed WELL below the historical 1.64% average annual return of an inflation adjusted market. In fact, the DOW pretty much got killed throughout the whole period.


Now lets take a look at another chart:



I often talk about the great debt bubble, and both of these graph illustrate how massive this bubble has become. We often talk about housing prices reverting to the mean, and folks, its really no different when it comes to the stock market.

As you can see there is a double top here. We hit it first in 1999(tech boom) and then again in 2008. How did we get back up here? The bull market fueled by the housing boom!! As you can see, the debt party which started in 1994 with the tech debt bubble, pretty much lasted right through the housing debt bubble with a short sharp recession in between.

Well now we have a couple of problems. First we have ran out of bubbles to blow up and we are in debt up to our eyeballs. The second is inflation.

Inflation is back!

This is the bigger problem we have in the future. Almost every economist has admitted that going forward, inflationary forces will be a major headwind for the economy.

A look at the charts above tells you how devastating this can be to an economy.

Itulip has 3 paths back to the mean in the second chart. If path 1 is chosen, we will see a 40% drop in the DOW to get back to the historical mean of 1.64% inflation adjusted growth on the DOW. The other option is the DOW will drop to a lesser degree, and we wait years for the 1.64% growth to catch up to where the DOW sits after more moderate drop. This is doubtful IMO.

Bubbles almost always seem to end violently. Time will tell.

Either way, equities do not look like a very good investment going forward.

More importantly, with the threat of inflation, the risk of a significant drop in stocks is probable when you look at what happened in the 1970's.

History always repeats itself.


5 comments:

James B said...

Jeff, I think this is an excellent find - very interesting indeed. But it leads me to the point that the Dow is a bad indicator given its limited basket of stocks (esp compared to the S&P500). I'd be really interested to see the same analysis on the S&P.
This once again shows how the pigmen works. Their quoted returns (which you accurately state as being double-digits...always) tend to be on very narrow slices of the truth. Anyone who believes those numbers shouldn't be investing (and of course those are the guys who get suckered!).

But I totally agree on the inflation story, which you've had tons of evidence in your blog to support for a long time. I was a little confused on the piece from Fisher than seemed to indicate the Fed cared about inflation as a priority, yet their actions betray that rhetoric. In what way are they showing concerns about inflation?

While I understand their need to keep an orderly financial system, it must have been obvious that the rate cuts only help the banks and cause incredible damage in terms of $ value and inflation. I've yet to see any convincing evidence that the Fed is *really* engaging the inflation bug.

Anyway, all that aside, I think your conclusions are spot on. The equity market is looking very, very bleak. Keep 'em coming, Jeff!

Jeff said...

Thanks Minton

I would bet the DOW and the S&P would look similiar in those charts. The markets as a whole all suffered in the '70's.

I agree the Fed has said they are watching inflation, but they have done nothing to fight it.

Fisher talked very tough on inflation, its just hard to find it because the speech is so long.

I have read some blogs were impressed with the language, but at the same time they are also calling him out to back up what he said.

We will see what Fsher does. If oil keeps rising the fed will eventually be forced to take action on rates.

James B said...

Yeah, I agree. I was very impressed with his speech, but I suspect the lack of action is because his vote is small compared to the others. He clearly is making this speech as a way to alert people - maybe because his colleagues are ignoring him? Either way, Fisher has it right but the Fed as a group is doing nothing about inflation from what we can measurably see.

You need to start posting 10 times a day. Your blog is the talking-point for most the conversations I have!

PS - I saw the stuff on GM - good stuff. I don't see a good way out for those guys, since they're 3-7 years behind the curve. The US auto business has been convinced for so long that 'bigger is better' that their adaptive capabilities is questionable.

Jeff said...

Minton

LOL...I will post as much as I can when I have the time.

Yeah GM and Ford need to totally retool their whole way of doing business.

It will be interesting to see if they can make the transformation before going BK!

Jeff said...

OMG! Look at this!

Minton here is another talking point for you. The Fed may start taking foreign collateral at the discount window!! Have they lost their minds!!???

You have got to be kidding me. Insanity. Credit crunch is over my a**. Can you say desperation?

This will be on the Time Bomb tomorrow.

Link for a quick peek if anyone wants to check it out:

http://www.marketwatch.com
/news/story/fed-fed-
might-accept-foreign
/story.aspx?guid=
%7BA2737127%2DB1AD%
2D4E18%2D81C6%2D0E
D1DF0AEC89%7D&dist=hplatest