The Myth Behind Record Highs in the Global Stock Market Indexes

November 1st, 2006

November 1, 2006 -

Recently, headlines about record recent highs in the U.S. Dow, the India Sensex, and the U.K. FTSE have dominated financial headlines. However, 99% of these articles never explore the new index numbers in the proper perspective. Just as I have mentioned in numerous previous blogs that paying attention to the U.S. Consumer Price Index as a proxy for real inflation or the Consumer Confidence Index as a proxy for true economic strength is dubious at best, so are the reports about all these record global markets. Why? Because 99% of these articles, and certainly almost all of them that proliferate throughout the mass media, never discuss the rise of these indexes in inflation adjusted numbers. So let’s look underneath the covers or inside the Halloween pumpkin, and see what we find.

The way “record highs” is being discussed in the financial media today is akin to saying just because your salary has risen by 10% over the past five years, that you are now earning a “RECORD SALARY” even if inflation over that same time period has risen by 20%. In this situation, the reality is that your purchasing power has decreased by 10% with your “RECORD SALARY” as compared to over five years ago.

In the U.S., record Dow headlines dominate the financial news world. Headlines scream that 14,000 Dow is on the way. Even if this does transpire in the future, if adjusted for inflation, a 14,000 Dow would still NOT top the high of the Dow six years ago, so we would not even be back to EVEN from six years prior. An inflation adjusted index, whether the Dow, the Sensex, the Paris Bourse, the Footsie, is the only proper way to interpret statistics.

Furthermore, though record Dow Jones Industrial Index (DJIA) highs have been dominating U.S headlines as of late and encouraging many people to plunge headfirst into the market, there is almost no discussion of the fact that the DJIA is a poor proxy for the health of the overall U.S. stock market. The Dow Jones Industrial Index is comprised of only the 30 largest and most widely held U.S. stocks and is hardly representative of the U.S. stock market. Furthermore, the DJIA is a price-weighted index where the movement of higher-priced stocks influences the index more than the movement of lower-priced stocks, even though a $3 single day gain in a lower priced stock may represent a 20% increase while a $3 single day gain in a higher priced stock may represent only a 5%.

That’s like taking a Los Angeles Laker bench warmer that only averages 6 points but has a monster game of 42 points and crediting him with only 21 points in the final score while granting Kobe Bryant full credit for all of his 30 points.

A much more accurate representation of the U.S. markets are the S&P 500 index or the Dow Jones Wilshire 5000, but no one seems to want to look at the more accurate picture. I already told you what insiders think of this market with the insider buy: sell ratios drastically dropping, but let’s also take a look at what reality is with the more representative U.S. indexes. On an inflation-adjusted basis, the Dow Jones Wilshire 5000 is 23% below its most recent peak in March, 2000. And even with the faulty DJIA index, on an inflation adjusted basis, if you had bought this index 6 years ago in January, even at its current levels, you would still be down more than 15%. And this type of analysis should apply to every index, no matter what region of the world it is in.

And remember what I said about the CPI in an earlier blog entry? The CPI typically underestimates inflation, sometimes quit significantly, due to its omission of food and energy costs. These figures that I just stated above use CPI figures to adjust for inflation, so even the inflation-adjusted numbers are rosier than the real numbers.

Though I have mainly discussed U.S. stock market indices in this article, the major points of this blog apply to all major stock market indexes all over the world:

(1) Understand the composition of the reported stock market index and what it represents.

(2) Dig below the surface to understand what is really going on. Remember all media is encouraged to invent sensationalistic headlines to attract readers, and thus advertising dollars. If you don’t, you are likely to be goaded into some poor financial decisions; and

(3) When assessing the health of your stock market, compare apples to apples. Look at inflation-adjusted numbers and NOT absolute numbers.

So with all the euphoria accompanying “record” levels of the current markets, it’s time to pop open the champagne bottles right? Yeah, right.

Entry Filed under: Most Read Posts, The Biggest Investment Myths, Wealth Literacy