Why Dow 11,000 Is Worth a Lot Less Now Than in 2001

The stock market is all about nominal prices. That is, prices that aren't adjusted for inflation or what analysts call "relative performance" -- how an investment has fared when compared with competing assets.

While this may seem like a parlor game, comparing how investments fare over time is a key element in portfolio management. Relative performance boils down to this: Sell assets that are historically overpriced, and buy assets that are historically underpriced.

The equities industry and the financial media tend to shy away from relative-performance analyses, and a few charts help explain this reticence. But in short, when adjusted for inflation, the stock market hasn't recovered as much as it appears to have when you look at only nominal prices.

Here's a 10-year chart of the Dow Jones Industrial Average (DJIA), which recently reclaimed 11,000, the same level it held about 10 years ago, in early 2001.

Adjusted for inflation (as per the Bureau of Labor Statistics), the Dow would have to reach 13,570 to equal the "purchasing power" value of Dow 11,000 in 2001. ($1 in 2001 equals $1.23 in 2010.)

Let's take a hypothetical investment in the Dow of $11,000 in 2001. That dollar amount equals the Dow's nominal price level. If a person has reinvested dividends from the $11,000 investment in the DJIA, that portfolio would now be worth about $14,066, based on the average Dow dividend yield of 2.66%.

So a "buy and hold" investor who reinvested dividends in the Dow for 10 years has stayed one step ahead of inflation, but not by much. The total return for a decade of ownership of the DJIA adjusted for inflation is a meager 3.6%.

Proponents of "buy and hold" have little to show for the past decade, and those who insist nominal prices are all that matters suffered a 23% decline in the purchasing power value of their portfolios, even though the Dow is near the same level it was in 2001.

Pricing Stocks in Barrels of Oil

Another way to perform a relative-performance analysis is to price an asset in something other than U.S. dollars. That might be gold, another currency or even a commodity like barrels of oil.

Let's say one "share" of the Dow equals its nominal price: If the Dow is 11,000, then one "share" is $11,000.

How many barrels of oil does one "share" of the Dow purchase? In 2001, the Dow was 11,000 and a barrel of oil cost on average $23. So one "share" of the Dow at $11,000 bought 478 barrels of oil.

If we adjusted that $23 per barrel for inflation, that price in 2010 would be $28.37.

How many barrels of oil would the current Dow buy at the 2001 price (adjusted for inflation)? One "share" of the Dow today ($11,000) would buy 388 barrels of oil priced at $28.37 per barrel. That means the Dow today buys 90 fewer barrels of oil than it did in 2001, even after adjusting the price of oil for inflation. That means the Dow underperformed oil by about 19% over the past decade.

But oil didn't just rise at the official rate of inflation. Today, the spot price of crude oil is $87 per barrel. So our one "share" of the Dow ($11,000) buys a mere 126 barrels of oil. So, compared to oil, the Dow has underperformed by a whopping 67%.

Put another way: $11,000 invested in oil in 2001 would have tripled, while $11,000 invested in the DJIA has either lost 23% when inflation is accounted for, or returned a modest 3.6% if dividends were reinvested.

What If You Were Paid in Silver?

In the early decades of the 20th century, my wife's grandfather was paid with a single gold coin. Just as a thought-experiment, let's say we worked in a silver mine and were paid in silver rather than U.S. dollars.

How would our pay just since July 1, 2010, compare with other investments such as gold, the S&P 500 and agricultural commodities? The following chart answers that.

Yes, the S&P 500 has soared 19% in nominal terms since July 1. But when priced in silver, stocks have lost a staggering 33% of their value in that period. When priced in silver, the U.S. dollar, undermined by the Federal Reserve's latest round of quantitative easing (QE2), has lost a stupefying 56% of its purchasing power value in just a few months.

Agricultural commodities have held their own when priced in silver, declining less than 1%.

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The point of this exercise is to show that "value" and "price" are relative. What matters is not nominal prices but what your money and portfolio returned in inflation-adjusted terms -- and what your money can buy in the real world. This is why purchasing power is a far more important measure of value than nominal prices.

This insight is the basis of The Economist's tongue-in-cheek "Big Mac Index," which compares the cost of Big Macs around the world.

Those who benefit from selling and recommending equities avoid relative performance analyses for good reason: Stocks have performed poorly compared to other assets classes over the past decade. As investors, it's up to us to do our own relative-performance analyses to help us conserve and enhance the purchasing power of our portfolios.