The Dow at 100,000?

Round milestones, the ones with many zeros, have traditionally been difficult for the Dow Jones Industrial Average to leave behind. The market hovered around 100 from 1906 until World War II — with a brief interlude in the 1920s, when it hit nearly 400 — and it needed a decade and a half to break through 1,000 in 1982.

And now, 10,000 has turned into an equally sticky barrier. The Dow first reached quintuple digits in 1999, but surrendered this level soon after the dot.com crash the following year. It regained it in late 2003, plunged last year and, with 2009 drawing to a close, broke through 10,000 once more.

Back in the late 1990s, Charles W. Kadlec, chief investment strategist at Seligman Advisors, wrote a book with a soon-to-become notorious title, Dow 100,000: Fact or Fiction. Remaindered copies of this masterpiece sell on Amazon.com for under two bucks, but Kadlec may end up looking like a prophet — albeit for the wrong reason.

Dollar Value

The composition of the Dow has changed over the years and only GE remains of the 12 companies included in the index in 1906. But the Dow still reflects the dollar prices of its 30 constituent shares, meaning that the buying power of the dollar impacts the value of the index.

Even though the U.S. economy expanded dramatically during the 20th century, all of the stock market appreciation from 1906 to 1982 was accounted for by inflation. In 1982, a hundred 1906 dollars was worth $1,074.72.

Not so over the subsequent quarter of a century. Since the rally on Wall Street began at the start of the Ronald Reagan era, the consumer price index roughly doubled. However, the Dow increased by a factor of 15 by the time it peaked in October 2007.

There have been plenty of reasons why this was a golden age for stocks: a pro-business climate, falling inflation, a high-tech revolution, a new emphasis on profits and cost control, a more entrepreneurial environment, the end of the Cold War and the opening of China and Eastern Europe, the maturing of baby boomers, etc.

More interesting is why stock prices stagnated during the 1906-1982 period, which saw the emergence of the United States as a world leader and its blue chip companies as global conglomerates. Actually, in the early post-World War II decades stocks didn’t stagnate at all.

In inflation-adjusted terms, the Dow rose almost as much in the quarter century between 1941 and 1966 as in 1982-2007. Over that period the CPI also roughly doubled, but the Dow jumped tenfold.

The problem years were the late 1960s and the 1970s, which was when inflation ran wild, nearly tripling in a decade and a half. Clearly, inflation was bad for business. It encourages consumption as consumers get rid of their depreciating dollars and depresses long-term investment and R&D — because no matter what the company produces will be snapped up anyway, and raising prices is no problem.

Asset Price Inflation

Economics is a relatively new and imperfect science. Although it has attained the same status as physics and chemistry when the Nobel Prize for Economics was established in 1969, it has more in common with medicine circa 1901, when the Nobel Prize for Medicine was first awarded. Back then, diagnostics was an art, pharmaceutics were in infancy and case histories and medical statistics were not gathered or analyzed systematically.

Aside from the supply-demand curve and its relationship with price, all other theories in economics are constantly challenged by reality — such as when in the 1970s we saw both high unemployment and inflation, which economists had said was impossible.

Recently, we have witnessed another amazing phenomenon. Consumer prices have been steady. In fact, most goods now cost less in nominal terms than they did a couple of decades ago, while their quality and variety have increased tremendously. Nevertheless, middle class families know that, while their incomes have gone up, they find it harder and harder to make ends meet.

Money just doesn’t seem to go as far as it used to. True, there has been an expansion of the typical consumer basket, both because there are so many new products and because many previous luxuries are now seen practically as necessities. Nevertheless, there has been a clear decline in the value of paper money that economists have not been able to measure.