Yes, Stocks Really Are at a Record High After Inflation

After the Dow Jones Industrial Average hit a new all-time high this week, a parade of cynics raised their hands and told everyone to slow down. Adjusted for inflation, they reminded us, the Dow is still well below its 2007 peak.

"Actually, the real Dow is still 11% below its record," wrote CNN.

"The Dow Isn't Really At A Record High," warned NPR.


Pardon me, but yes, it is.

It is true that the Dow is below its 2007 high when adjusted for inflation. But Dow companies have paid hundreds of billions of dollars in dividends over the last five years. Dividends are every bit as much a part of an index's returns as price movements are, so they have to be added back in to get a sense of actual performance.

Dow Jones tracks a version of its famous index that includes dividend payments. Adjust it for inflation, and stocks really are at an all-time high:

 

Source: S&P Capital IQ; Federal Reserve; author's calculations.

A simple way to think about this is that inflation has averaged about 2% a year since 2007, while the Dow's dividend yield has averaged more than 2.5%, so any adjustments push the nominal value of the index up. Adjusted for both inflation and dividends, the Dow actually hit a new record high six weeks ago.

Why would investors and commentators ignore dividends? Thank the overwhelming shortsightedness of markets as a whole. The average stock is owned for about seven months. Dividends are truly insignificant during that period, even for a high-yielding stock. But when you measure in years or decades, dividends become one of the most important components of returns -- particularly if they are reinvested. Since 1871, the S&P 500 (as recreated by Yale economist Robert Shiller) has gone from 4.5 to 1,544, generating an average annual return of 4.2%. But factor in the reinvestment of dividends, and the index actually jumped from 4.5 to 807,556 for an average annual gain of 8.9%. With inflation and dividends, the index rose from 81 to 807,556, or an average annual gain of 6.8%.

Dividends are even more important during crashes and bear markets, as falling stock prices push dividend yields up. One oft-cited statistic is that it took 29 years for stocks to hit a new peak after the Great Depression after factoring in inflation -- from 1929 to 1958. While this is true, if you include dividends, stocks were at a new real all-time high just seven years after the previous peak. The discrepancy between the two dates is so wide because stock prices fell so low during the Depression that the dividend yield on stocks rose as high as 14% in 1932. Even after companies slashed dividend payouts as the economy collapsed, the dividend yield on the S&P 500 averaged 7% in the 1930s. Ignoring the impact this has on returns provides a completely false view of reality.

It was similar in the 1970s and '80s. If you look at inflation-adjusted stock prices, the S&P 500 was virtually flat from 1968 to 1992 -- almost a quarter-century! But add in dividends, and the index actually returned 170% during the period, even after inflation.

What's odd is that most investors are well aware of the destructive power of inflation but often oblivious to the compounding power of dividends, even though the latter has historically been higher than the former. Why? Perhaps because inflation is ever-present regardless of what you do, while harnessing the power of dividends takes patience to stick it out through bear markets. This is just another reminder that markets reward those willing to wait. 

For more on dividends, check out the Fool's special report: "The 3 Dow Stocks Dividend Investors Need." It's free, so just click here and get your copy.

The article Yes, Stocks Really Are at a Record High After Inflation originally appeared on Fool.com.

Morgan Housel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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