Consumer Price Index

February 25, 2011

Do a Google image search for "rich woman", and for some reason this picture of Malcolm Gladwell comes up

Welcome to Recycle Friday, in which we dig up the carcass of a vintage guest post of ours and see how it stands up in the modern era. Today’s originally ran on 20sMoney last year. Annotations in CYC maroon:

Today’s happy headline (“Your mutual fund is hurting worse than you think”) necessitates a little look back. How does today’s Dow Jones Industrial Average compare to, say, the Dow of February 1997?

Answer: It doesn’t. Sure, the average is 10,192 today (12,069 this morning, baby! The proverbial gravy train with biscuit wheels! Start borrowing!) and was around 6900 twelve years and 3 months ago, but…the average of what?

The Dow is the sum of the prices of 30 of America’s largest stocks, multiplied by a constant. But the roster of stocks itself isn’t constant. Here are some of the blue chips that comprised the Dow in ‘97:

General Motors
Citigroup
AIG

(This is already reading like a list of notorious contemporary eradications. Despite where we appear to be heading, the next items on the list are not the Seattle SuperSonics, the French franc and Lindsay Lohan’s career.) (Those semi-pop culture references still hold up, kind of. Maybe we could trade out Charlie Sheen for Lindsay Lohan, but that’s it.)

Altria
Honeywell
Eastman Kodak
International Paper
AlliedSignal
3M
Goodyear
Sears Roebuck
Union Carbide
Bethlehem Steel
Westinghouse
Woolworth

That’s almost half the then-Dow, consisting of the infamous and the doddering. Today, these names sound as though they belong in some bygone epoch of American proto-commerce. (Woolworth, if you’re interested, took scarcely more than a generation to fall from five-and-dimes with lunch counters that wouldn’t serve black people to sneaker retail. The company shed all its fat and kept its one legitimate asset, which is now its successor company – Foot Locker.)

So yes, the Dow has “risen” 60% since the cloning of Dolly the sheep. But that’s comparing today’s Dow to something that no longer exists. A basket of 1997 Dow stocks wouldn’t have risen anywhere near 60%: a lot would depend on whether you used your General Motors certificate to make a paper airplane out of or wipe up kitchen spills with.

(Since then, General Motors made a comeback of sorts. The old shares were indeed rendered worthless, thanks to a federal government that decided that GM’s bondholders and owners didn’t matter as much as its employees – or more importantly, its employees’ union bosses. The new shares began selling on November 18 at $34.19. Fortuitously, they just happened to have dropped a record 5% yesterday to close at $33.02. Did we mention that your tax dollars are responsible for this? We did.)

(No Dow stocks have changed out since Cisco and Travelers joined in 2009. In fact, none of the current 30 are even in trouble.)

Conversely, if you’d had the foresight to invest in stocks that were to become Dow components –Verizon, AT&T, Chevron, Cisco, Intel, Pfizer et al. – you’d have enjoyed a lot more than a 60% return over 12 years. But you’d have had to predict that cell phones would become ubiquitous, gas prices would rise, every new electronic component would need a router, and every man in America would convince himself that little blue pills were the only things standing between him and a happily exhausted wife.

What about companies that barely existed in 1997? Google didn’t trade publicly then, and wouldn’t for years. Yahoo! did, at around $1. Each company’s profound growth remains invisible to the Dow.

Because the Dow regularly replaces its weaker components with stronger ones, its levels can mislead. Only if you own a Dow index fund – a basket of stocks that consists of equal proportions of Dow components, and whose makeup changes as the Dow itself changes – can you truly track that investment consistently over the years.

But because the Dow is measured in dollars, or at least a mathematical manipulation thereof, you have to account for inflation. The Consumer Price Index has risen 37% since February of 1997. (And 1.4% annually since this post first ran. Are we ever going to see the hyperinflation we’ve been anticipating?) (The Consumer Price Index is subject to biases of its own, but explaining them would require a few thousand more words.) The Dow itself has risen 43% in that same period. (See above.) So in real dollars, a Dow index fund has appreciated .4% annually since then. Two-fifths of a stinking percent, and that’s ignoring broker fees. Should the Dow drop another 400 points – and it dropped half that much in the last 10 minutes of trading on May 23 – that’d wipe out every penny of those miniscule gains. That’s one term of Clinton, two terms of Bush, and a term-in-progress of Obama with no appreciable gain in the Dow.

(The changes since then amount to a rounding error. Seriously, it’s up to an annual increase of 1.8%. Maybe things really are looking up, if by “things” we mean “stocks” and by “up” we mean “harder to buy”.)

Your conservative neighbor whose entire portfolio is 3-year CDs doesn’t look so stupid now, does he? Yes, it’s easy to look back with perfect eyesight, but there is such a thing as overdiversification. And while that’s never as dangerous as riding the waves with only one or two stocks, it does lower your ceiling. When you put your eggs in one gigantic uber-basket, you’re not giving undervalued, bargain stocks a fair chance to boost your portfolio.

At Control Your Cash we shudder at the idea of frequent and indiscriminate turnover. A stock is an investment, not a blackjack hand. But we also hammer one primary mantra: Buy assets, sell liabilities. Do that often enough and you can’t help but get rich. Overpriced Dow components (and other big companies) with poor fundamentals are almost always liabilities.

(Fortunately, Dow Jones Inc., the folks who determine which stocks comprise its bellwether index, have gotten a little more pragmatic lately. A company’s history, or its influence of a couple generations ago, is no longer as important as what it’s done for us lately. Maybe those fancy semiconductors and software really are here to stay.)

**This post is featured at the Totally Money Carnival #9-Funny Baby Videos Edition**

Stick a Pin in it, It’s Done

July 18, 2010

I can't make change, all I have are quadrillions

Control Hoard Your Cash

Cash is a bad investment, right? Not as bad as penny stocks, perhaps, or California muni bonds, but certainly not much better.

Besides, can you even call holding cash “investing”? Does it fit the definition of using money to generate potential profitable returns?

It can, when deflation happens.

Simply spend enough time on this planet, and you’ll be conditioned to believe that prices and wages inevitably rise- and that what a dollar bought a year ago, it’ll buy slightly less of today.

2010 is an outlying economic year for many reasons, not the least of which is the possibility/certainty of deflation.

Well, that and the gargantuan government spending. Our apologies if we used the word “gargantuan” in a recent post: we’re running out of adjectives that denote bigness. According to the economists at the Bureau of Labor Statistics (which spends an average of $2 per taxpayer per year), the consumer price index fell .1% last month, .2% in May, and .1% in April. Those numbers look miniscule, don’t they? Harmless, even. But keeping in mind that the numbers are several, and that they determine a trend, it might be time to start worrying. It’s hard to draw too many conclusions when the BLS only ratiocinates to one decimal place, but cumulatively, the above numbers tell us that prices have fallen somewhere between 2.5% and 5.4% in a mere 3 months.

Great news for spenders. Rotten news for savers. If that 3-month average were to maintain itself for a year, we’d be looking at a 20% decline in prices.

So what’s the downside to this? You’re complaining about lower prices? God, you really are a killjoy. You probably complain about how sweaty things get during sex, too.

It’s not that simple. Prices and wages usually move in lockstep.

So things are neither better nor worse than usual, then.

Not quite. Say you have a long-term obligation, like a 30-year fixed mortgage. One of the features people like about mortgages that last so long is that by the time you get to the end of the term, the payments will be tiny. They’ll be as large in nominal terms as they are today – fixed rate means if you pay $1000 a month in Year 1, you’ll pay $1000 in Year 30.

Go back to 2005, when annual inflation was close to 4.0%. That’s pretty close to the historical average, maybe a little higher. Say your monthly payment was $1000. If prices rose at 4% throughout the term of your loan, the final payment would be the equivalent of only $321 in constant dollars.

When deflation happens, those payments get progressively harder to make, not easier. During deflation, it’s great to be owed money, less great to owe it. Extended deflation makes banking less viable as an industry. If prices are dropping 20% annually, bank rates have to lower accordingly. That 1-year CD that pays barely 1% in nominal terms thus pays 21% in real terms. Banks aren’t in the habit of throwing money away, which means they’ll stop offering anything other than super-risky loans. If you can keep money in an ammo box buried in your backyard, and enjoy a real rate of return of 20%, banks outlive their usefulness.

A little inflation isn’t all that bad. You could almost argue that it’s crucial for a healthy economy, in that it gives people an incentive to lend and borrow (the latter in hopes of larger returns, the former with the comfort of guaranteed returns.) Deflation isn’t exactly a sign of a robust economy. Again, it usually means wages are decreasing on average, which upon further examination often means that wages are staying the same, just the number of people employed is decreasing, thus lowering the mean. The latest sustained period of deflation in this country’s history was from 1930 to 1933. Go ask your great-grandparents how much fun it was to escape the Great Plains while John Steinbeck wrote books about them and Woody Guthrie sang songs about their plight.

Thanks for the history lesson. How does this help me now?

Get out of that dying industry that you work in, where your shaky paycheck is sustained at the whim of your employer.
If you’re at the point where you’re looking at passive income to supplement or outperform your active income, a) nice going and b) don’t get locked into modest rates. Instead of a conservative money-market account, see what your bank is offering in terms of certificates of deposit. Don’t be shy about shopping around, either: there’s no rule that says you have to keep all your accounts at the same bank. In fact, almost no rich people do. Use the CD ladder technique, which manages to get your entire investment to pay long-term returns even though you’re only in it for the short term.

You want more details on that? You can wait for it to find its way into the rotation as our weekly free book excerpt, but by then the economy could be riding a hyperinflationary thermal for all we know. Or you can one-click your way here.

**This post was featured in Canajun Finances’ Best of Money Carnival #61.**

**This post is featured in the Carnival of Personal Finance #267**