Sure the Dow has been hitting nominal highs lately. But it won’t be a real Dow record high until we move a little higher, thanks to our frenemy inflation.
There’s a lot of excitement in investing circles surrounding all of the recent milestones hit by the Dow Jones Industrial Average. The Dow broke through 16000! The Dow ended above 16000! This is a new high!
It’s true that the Dow recently made it through the 16000 mark for the first time ever. But that’s just the?nominal?high. My buddy InvestorJunkie and I were talking about the stock market yesterday, and he pointed out that we have a little ways to go if we are going to see a?real?Dow record high.
Our Frenemy Inflation
The reason we talk about nominal (in-name) and real highs for things like stocks and income is due to inflation. Inflation is the frenemy of the finance world. It?looks as though things are going well because the numbers are higher. You make more money, or the stock market busts through increasingly-ridiculous levels (could we really see Dow 30000?).
In reality, though, the nature of inflation means that you aren’t seeing as much value as you think you’re seeing. Inflation is the erosion of your purchasing power. It’s a general rise in prices. Inflation is the reason that it takes more money to buy the same thing over time. Think back to your childhood. Think about how much candy you could buy with a dollar. Now, think about how much candy you can buy now with a dollar. You can buy less candy with the same amount of money, or you can spend more money to get the same amount of candy. That’s inflation.
By The Wall Street Journal’s measure in terms that take account for inflation over time, the Dow record high won’t be reached until it hits 16219.52. Right at this very second, the Dow is at 16095.74. Yes, the Dow has logged session after session of gains, and investors seem to manifest exuberance over making this real?Dow record high?happen.
Is the Dow a Good Measure of the Economy?
We can’t forget, too, that the Dow Jones Industrial Average is often touted as a measure of economic health. The Dow is gaining, so the economy must be improving. It’s a nice thought, and stock market performance (don’t forget about the S&P 500 and the Nasdaq!) can provide clues about how things are going. But it’s important not to put too much stock in the Dow. Remember: It’s actually composed of very few of the stocks on the market. It’s true that they are all rather large and influential stocks, but there are still?only a few of them.
It’s also important to remember that good stock market performance can give us a false sense of security about how your own financial picture looks. The recent improvement in 401(k) balances is a good example. Yes, balances are growing. But that’s due largely to the recent stock market rally. All of that wealth disappears suddenly if there’s a crash.
This doesn’t mean that you shouldn’t invest in stocks, however. Over time, stocks still provide one of the best ways to grow wealth. Even a big 5000-point drop right now would still put you ahead if you bought stocks in 2009, or if you had been investing since the 1990s.
You just need to have a realistic view of the situation. Don’t get caught up in the hype of a Dow record high (although paying attention to such things could prevent you from being taken by surprise with a crash, since it can indicate that we are in a bubble). And later, when things go bad for a little while, don’t panic and sell your investments at a loss.
What do you think? What happens after we hit the inflation-adjusted Dow record high? Are we headed for another crash?