Avoid This Stock Market Excitement

Investment club watching Dow hit 40,000

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It’s everywhere – The belief that the stock market is in a new growth phase. The proof? The media’s full-blown reporting of the stock market indexes’ new highs. The latest is the Dow Jones Industrial Average (DJIA) reaching 40,000 for the first time.

So, what’s wrong with that clear evidence? Inflation. It infects everything measured and analyzed in dollars. And when it’s high, like now, it significantly overstates growth and improvement. The stock market is especially vulnerable to inflation’s misleading effects.

A good example is the DJIA reaching 40,000

Adjust for the Covid period’s 21.1% cumulative inflation, and that 40,000 becomes 33,000. Moreover, that inflation-adjusted level was first reached three years ago, in April 2021. Here is the picture, showing the DJIA as reported and adjusted for inflation.

DJIA as reported (orange) and inflation-adjusted (green)

John Tobey (FRB of St Louis – FRED)

So, what is the conclusion?

First, the DJIA has yet to break through its 3-year-old high. Second, because it is at its previous high, it carries both the hope of a breakthrough and the concern that it may fail to do so and retrace its recent run-up.

Okay, but that is the stodgy Dow – What about the S&P 500 and the Nasdaq?

This is where “widespread” becomes visible. Start first with all three indexes as reported. New highs for all.

Three major U.S. indexes as reported

John Tobey (FRB of St Louis – FRED)

Now add the CPI (All items) index. While the stock indexes are above, the CPI shows the high rise.

Three indexes compared to CPI

John Tobey (FRB of St Louis – FRED)

Now to the inflation-adjusted indexes. The new highs disappear, thereby creating the previous mix of hope and concern everywhere.

Three indexes, inflation-adjusted

John Tobey (FRB of St Louis – FRED)

Another way to see inflation effect: Adjust even number levels

This graph shows how the “real” levels changed over the Covid period. Clearly, the DJIA needs to rise over 2,000 to get to adjusted 35,000 and over 8,000 to reach adjusted 40,000.

Inflation-adjusted for main index levels

John Tobey (FRB of St Louis – FRED)

What about the better performance by the S&P 500 and Nasdaq?

The primary reason is the market capitalization weightings. Because the largest companies have been in favor, the two indexes have been positively affected. Additionally, growth stocks have outperformed value, and that has helped the Nasdaq outperform the S&P.

But there is a warning in those differences. Today’s return to the 2021 highs shows the same differences as back then. So, is this stock market environment a newly forming bull market foundation? Or is it just a return to what worked before, meaning there could be a reversal coming?

The bottom line: Remember when the media agrees wholeheartedly, it is time to be a contrarian

The media claims the stock market is in a new all-time high growth phase. Adjusting for inflation produces the “real” picture that negates that view. Therefore, now is a time to be a careful realist, not an enthusiastic optimist.

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