“Yah, but adjusted for inflation, it has another 1900 points to go.” That skeptical retort accompanies most coverage of the Nasdaq, which finally topped its dot-com-era peak on Thursday. The magic number was 5048.62, but many claim the index won’t truly have made up all lost ground until it hits 6941, which some stat people claim is 2000’s peak adjusted into today’s dollars.[i] We’ve seen similar arguments about the S&P 500, and they are all, frankly, bunk. Nominal index levels don’t require asterisks.[ii] Some things make logical sense to adjust for inflation, but stock returns are not one of those things.
In the realm of savings, inflation is a negative force that erodes purchasing power over time. A dollar buys less today than it did in 2005 and will probably buy less, still, in 2025. So many savers invest in appreciating assets in hopes the growth they achieve in the long run will outpace inflation, preserving or even boosting their purchasing power.[iii] They want their nominal portfolio value to rise so they can buy more with tomorrow’s dollars. If nominal growth outpaces the inflation rate, then they have succeeded. For an individual investor, adjusting personal returns for inflation would be a quirky, pointless exercise—you spend nominal dollars, not inflation-adjusted dollars.
No one bats an eye when applying the same logic to governments. When calculating debt-to-GDP, national treasuries, statistics agencies and economists alike use nominal GDP. Yes, real GDP better reflects actual economic growth, but governments don’t service debt in inflation-adjusted terms.[iv] If Uncle Sam floats a 10-year bond for $1000, in 10 years, the bond owner gets $1,000 back. Not $1,000 plus inflation. And that debt is financed with nominal dollars. Hence why super-indebted countries will sometimes monetize their debt, printing scads of new money to “inflate it away” or pay it off.
It’s the same for regular folks! We can’t print money[v], but folks take advantage of inflation all the time. It makes fixed mortgage and car payments less burdensome over time—the payment stays the same, but as wages and salaries rise with prices, a smaller percentage of the borrower’s total income goes toward those high fixed costs. Jim and Judy Homeowner would never think to inflation-adjust their income to gauge whether they can continue affording a mortgage they took out 15 years ago. They’d compare their monthly payment to the actual amount they’re earning today.
Companies think in the same terms. They don’t inflation-adjust earnings, costs or the expected return of long-term projects. When you own stock, you own a slice of those future earnings. So why adjust the price for inflation if what you’re buying—its profits—are nominal? Heck, inflation has a direct impact on every company’s bottom line—on costs and revenues alike. If a company has overseas costs and revenues, then currency swings and foreign inflation rates play a role, too. Trying to adjust for all that opens the door to significant statistical manipulation, which we have a hard time seeing as more “pure” than the raw, nominal numbers. Adjusting none of it—stock price, earnings and all that go into them—is simply more transparent and makes it easier for investors to compare Company A with Company B.
Plus, inflation-adjusting isn’t an exact science. Yale Professor Robert Shiller, whose cyclically adjust price/earnings ratio uses inflation-adjusted earnings and stock prices, said it best: “Introducing indices of price inflation introduces the possibility of error.” For one, what inflation index do you use? When most folks think of inflation, they think of CPI—but is an index of consumer prices really the best way to adjust corporate earnings? Shiller and his CAPE partner, John Y. Campbell, used an obscure producer price index, which roughly approximates corporate costs, but that isn’t much better. Inflation baskets’ components also change over time, and indexes are subject to historical revision—more skew. And none get at what an investor would really care about, the change in their own cost of living over time. There is no way to achieve logic and consistency.
Inflation-adjusted stock returns are ivory tower trivia—nothing more. (Heck, so are nominal index all-time highs.) To the average investor, it makes no difference whether a given index is below, at or above its prior peak adjusted for some arbitrary index of historical prices.[vi] That isn’t real life. Real life is the value of your own portfolio and how it moves over time compared to your costs—not just the inflation of your personal costs, but your changing costs (like the rise in health care expenses typical of most retirees).
Sure, sometimes your returns won’t outpace inflation over short periods—such is the nature of volatile markets. But adjusting indexes for inflation—particularly in the all-time-high debate—invites a heightened focus on the recent past, which can lead to behavioral errors. You might cure nominal breakevenitis and fear of heights, but with the side-effect of increasing inflation fear, inflation-adjusted breakevenitis and acrophobia.[vii] Or taking excess risk to try to make up lost ground relative to prices in a hurry. As ever, we encourage taking a longer perspective: Over time, stocks’ annualized 10% return has blown away CPI’s average 3% rise. Stocks are a marvelous inflation hedge in the long run despite occasionally being under “real” highs at times in the near term.
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[i] This is a moving target, of course. We’ll probably have some inflation between now and 6941, which would push the goal posts out farther.
[iii] Here one might say “yah, but, if you were in the Nasdaq the whole way, you would have lost purchasing power over the past 15 years!” To which we say yah, but, why start the arbitrary comparison there, at the peak, when many investors bought in earlier? How many investors really rode the Nasdaq and the Nasdaq alone the whole way? Plus, the Nasdaq is a price index, which doesn’t include dividends. So the whole comparison of the Nasdaq index level and household purchasing power is largely useless.
[iv] Mostly. Many countries have a handful of inflation-protected/linked treasury bonds. But they are still paid with nominal dollars.
[v] Counterfeiting is against the law.
[vi] Nominal record highs aren’t meaningful, either. They’re arbitrary and backward-looking. Real all-time highs are just extra-arbitrary, inflation-adjusted backward looks.
[vii] Acrophobia is fear of heights. It is decidedly not allodoxophobia, which is the fear of opinions. We don’t have that, either.