Avoid the excitement of the stock market

It is everywhere – the belief that the stock market is in a new phase of growth. Evidence of? The media reported the new high of the stock index in earnest. Recently, the Dow Jones Industrial Average (DJIA) reached $40,000 for the first time.

So what’s wrong with that clear evidence? inflation. It infects anything that is measured and analyzed in dollars. And when it’s as high as it is now, growth and improvement are greatly exaggerated. Stock markets are particularly vulnerable to the misleading effects of inflation.

A good example is the DJIA hitting 40,000.

Adjusting for cumulative inflation of 21.1% during COVID-19, 40,000 becomes 33,000. Moreover, the first time it reached that inflation-adjusted level was three years ago in April 2021. This is a diagram showing the DJIA as reported and adjusted for inflation.

So what’s the conclusion?

First, the DJIA has yet to break out of its three-year high. Second, with stocks at previous highs, there is both hope for a breakthrough and concerns that the stock will fail and regain its recent gains.

Okay, but it’s the Dow. What about the S&P 500 or the Nasdaq?

This is where “spreading” comes into view. We start with all three of his reported indices. A new high for everyone.

Next, add the CPI (all items) index. While the stock index is rising, the CPI is showing a high increase.

Next, let’s talk about the inflation-adjusted index. New highs disappear and with it a mix of previous hopes and concerns everywhere.

Another way to see the inflation effect: Adjust the even level

This graph shows how ‘real’ levels have changed during the Covid period. Obviously, the DJIA needs to go above 2,000 to reach the adjusted value of 35,000 and above 8,000 to reach the adjusted value of 40,000.

What about the improved performance of the S&P 500 and Nasdaq?

The main reason for this is the weighting of market capitalization. The two indexes are positively influenced because they are supported by the largest companies. Furthermore, growth stocks are outperforming value, which is why the Nasdaq outperforms the S&P.

But these differences come with a caveat. Today’s return to 2021 highs shows the same difference as then. So, is this stock market environment the basis for a new bull market? Or does it mean that a reversal can occur simply by returning to a situation that worked well before?

Bottom line: Remember, when the media wholeheartedly agrees, it’s time to be contrarian.

The media claims that the stock market is entering a new period of record growth. Adjusting for inflation creates a “real” situation that refutes that view. So now is the time to be a cautious realist rather than a fanatical optimist.