A Look At The Huge Gap Between The Nominal And Inflation Adjusted Dow

An email I received earlier today commented on the difference between nominal and real (inflation-adjusted) charts of market data. The overlay below of the Nominal and Real (inflation-adjusted) Dow illustrates the concept of Money Illusion, the tendency of people to think of currency in nominal, rather than real, terms. Below the two Dow series is the Consumer Price Index (CPI) from 1913 and with estimates for the earlier years. The CPI is the inflation (deflation) multiplier that accounts for the difference between the two views of the Dow.

Chart 1

One of the most conspicuous differences between the nominal and real series is apparent during secular bear markets, such as the period from the mid-1960s to 1982. In the nominal chart, this period looks like a choppy sideways pattern. But when we adjust for the high inflation of the 1970s and early 1980s, the sideways chop becomes the cascading downward direction of the real value of the market price. The 1982 dollar had shrunk in purchasing power to about 33 cents in comparison to its 1965 counterpart. Inflation had devoured two thirds of its value.

In the chart above I adjusted the real Dow price to the dollar value of May 1896 to highlight the money illusion over the entire time frame. More commonly my inflation-adjusted charts are priced at the present value of the currency, as illustrated in the real series below. This has the effect of raising the numbers for the earlier periods to adjust for the effect of the dominant pattern of inflation with brief but vicious periods of deflation, especially in the earlier decades.

Chart 2

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