The "Where?" Part I: Intro to Inflation

In order to best protect yourself, you need to know where you are in the grand scheme of things. In order to do that, you're going to have to have some comfort level with charts and some fundamental concepts like inflation, money, and fiat to begin. There's probably no better way to understand these ideas than to look at the stock market over time. By the time you're done with the first two parts of this primer, you'll know more than 90% of people out there about money and wealth...

Note that it is going to be impossible to completely explain every facet of things. The goal here is to simply get you started, perk your curiosity, and give you some resources to continue your investigation. If you're going to follow the markets and understand what's likely going to happen in the future, you're going to have to become a student of the markets. That's going to take some time and dedication--just get on it because the hour is late.

We've included links for much of this primer so you can easily take advantage of external learning resources.

The financial markets consist of many different facets. There are stock markets, commodities markets, foreign exchange markets, bond markets, derivatives markets, and other types of markets that trade in securities.

It helps to have visibility into all of these securities markets to best understand where we are. However, first we're going to focus on the stock market, also know as the equities market.

A share of stock represents a piece of ownership of a company. If you buy stock in McDonald's, then you technically own a piece of that company and may have certain benefits of ownership (like dividends and voting rights). The stock itself is bought and sold on a stock exchange like the New York Stock Exchange (NYSE), the NASDAQ, or the Euronext.

Stocks often, though not always, reflect the health (or anticipated health) of the economy. For example, if Microsoft's business is going well because they are selling a lot of new software, then you would expect their stock price to go up. To the contrary, if their business is doing badly, investors tend to sell their stock which drives the price down (we'll cover supply and demand a bit later, so just trust us for now).

Stock indices, like the Dow Jones Industrial Average and the S&P 500, the are often used to measure the performance of specific sectors of the market. The Dow Jones Industrial Average, for example, contains the stocks of the 30 largest and most widely owned stocks in the United States. Indices are good ways of viewing the health of a particular portion of the economy. If the Dow Jones Industrial Average is rising, the expectation is that the biggest companies in the United States are expecting to make more money. That's considered a good measure of the business performance of the United States, and of course, if business is good, the implication is that people are out buying things. If they're buying things, then they must be employed and have positive belief in the future.

The S&P 500 is, for our purposes, the best measure of the health of the business of companies in the United States. As we start publishing more technical analysis, you will see that we prefer to rely on the S&P since it contains 500 companies, whereas the Dow Jones contains only 30. However, in this analysis, since we're going to use a lot of very historical data, we'll be relying on the Dow Jones since it was the first stock index published in the United States in 1896.

The first thing we want to do in our analysis of "Where?" is to look at the whole history of the US economy as measured by the Dow Jones Industrial Average and see if there's anything we can learn from it. The chart below shows the Dow Jones Industrial Average closing price from 1896 - present.


Note that below is the same chart, but with red arrows, dates, and values so that it makes the rest of this primer easier to follow.



This chart shows the price of the Dow Jones Industrial Average (which we'll call DJIA from now on) when the stock market ended for each day the stock market was open. It is a daily chart because the data has the last price for each day. We could also use weekly prices or monthly prices (and we will for different things later on). Note, you should keep in mind that the DJIA is measured in dollars. That makes sense, right? Later on this will be important.

The first thing that you should notice is that this is really tough to read the older data since this is a linear chart. Since the DJIA has risen from roughly 41 in 1896 to over 14,000 by 2007 (again, in truth that's $41 from 1896 to $14,000 by 2007), it makes the older data difficult to read. For example, in the chart above, in April of 1942, the DJIA was approximately at the 100 ($100) mark. In February of 1966, the DJIA was approximately at the 1000 ($1000) mark. By April of 1999, the DJIA was approximately at the 10,000 ($10,000) mark.

Some important notes:

• The DJIA stayed below 1000 ($1000) from May 26, 1896 until November 14, 1972--that's more than 76 years.
  
• Between 1972 and 1982, the DJIA was basically floating between $800 and $1000.
  
• In 1982, it broke out, which means it started rising like crazy. In fact, between 1982 and 2000, the DJIA rose from roughly 1000 to 11,000.
• From 2000-2007, the DJIA rose to 14,000 or so, and since then it's fallen substantially from 14,000.

That move from 1972 forward is not just a coincidence. Nixon took the United States off of the gold standard. This was a very important development, as we'll get into a bit later. But in brief, it has everything to do with inflation...

The linear chart nicely shows how large the price swings have been in the last 100+ years, but it's hard to see any patterns that we can work with.

Another way of viewing the same data is with a logarithmic chart. This makes the data easier to view. Please note that the values are not changed at all--it is simply a visual change.


And again, with arrows and values to make it easier to follow.


This chart is much more readable. The price movements are more clearly defined. In a logarithmic chart, the space between any two horizontal lines is the same percentage difference. Let's look at the same time periods we looked at in the linear chart. In April of 1942, the DJIA was approximately at the $100 mark. In February of 1966, the DJIA was approximately at the $1000 mark. That's a ten-fold increase. By April of 1999, the DJIA was approximately at the $10,000 market. That's another ten-fold increase. It's easy to see these numbers on the logarithmic chart--to know when the DJIA went up some percentage (in this case, 1000%).

If you had bought the DJIA stock index in 1942, it would have cost $100. By 1999, that $100 would have grown to $10,000.

But, looks can be deceiving. The real problem that we have today is that we **assume** (wrongfully) that the value of our money is constant. We see prices of things rise--movie tickets, groceries, fuel, etc. But we often don't think about WHY they rise--often, the value of the things we buy don't rise, but the money instead loses value. Next, we're going to have to talk a bit about what money is and is not, and what inflation is and is not. Then we're going to look at the same charts again from a different perspective.