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09/27/12 09:44:48 AM PST
by Ron McEwan

Often, we forget to take inflation into account when calculating long-term returns. Here's how you can include this necessary variable and get a more realistic picture of your returns.

 As I write this, it is mid-September 2012 and the markets are reaching for all-time highs again (for the third time since 2000). Also reaching new highs are the prices of gas, food, and many everyday living necessities. With the indexes at these levels, why does it seem like purchasing value is going down? The talking heads on the business news attribute this to inflation. Does this explain why markets are higher in dollar value and why they seem to be worth less in purchasing value?ADJUSTING FOR INFLATION To answer these questions, I looked at the markets with an inflation adjustment. This is a simple matter of entering monthly price data for the index or security of choice. Here I used the Standard & Poor's 500 series back to 1871. The data for the CPI (Consumer Price Index-All Urban Consumers) is also required. The CPI data is available from the US Bureau of Labor Statistics. The spreadsheet (Figure 1) consists of six columns. The first column is the date field. The second is the monthly closing price for the security series being adjusted for Inflation (S&P 500). The third column is the monthly CPI figure. In the following (fourth) column, the return for the month-to-month CPI is calculated as `((this month's CPI minus last month's CPI) divided by((this month's CPI plus last month's CPI) divided by 2)) "((C3-C2)/((C3+C2)/2))"` The cumulative rate of inflation is calculated in the fifth column by entering 1 in cell E3 and the formula E3 * (1 + D4) in column E4. Copy this formula down to the end of your data series. The next step, in column F, is to multiply the monthly close (column B) by the cumulative rate of inflation (column E). Again, copy this down to the end of the data series. Your workbook should look like what you see in Figure 1. FIGURE 1: PRICE ADJUSTED FOR INFLATION. Here you see how you can adjust price for inflation on an Excel spreadsheet. If you plot columns A (date), B (price), and F (inflation adjustment), you can compare the original price series for monthly closing prices to the data series that was adjusted for inflation over the same period of time. Figure 2 examines the monthly closing price for the S&P 500 going back to 1871. Figure 3 covers the period for the 1929 market crash. As you can see, inflation kept up with market performance, in up and down moves. In Figure 4, you can see more closely that while the markets are attempting to regain their previous highs, inflation appears to be eroding the value of this move. FIGURE 2: S&P 500 VS. INFLATION-ADJUSTED PRICE. Here you see the monthly closing prices for the S&P 500 going as far back as 1871.FIGURE 3: S&P 500 1929 MARKET CRASH VS. INFLATION-ADJUSTED PRICE. Note how inflation kept up with market performance.FIGURE 4: S&P 500 CURRENT VS. INFLATION-ADJUSTED PRICE. Markets are attempting to regain their previous highs, but inflation appears to be eroding the value of this move. BE CAUTIOUS The current spread between real market prices and inflation-adjusted prices should be viewed as ominous. How this discrepancy eventually resolves itself may not be welcome to long-term investors.

Ron McEwan

Ron McEwan is an independent trader and market technician. He may be reached at rmac@juno.com.

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