Price of bread at record high!

HEARD the one about the sharemarket's new record high? On Wednesday the Dow Jones Industrial Average briefly breached the 14,000-point level, and on Friday the sharemarket barometer closed above 14,000 for the first time, at 14,000.41.

Even last week, as the Dow picked up sharply, we were hearing about "A record day on Wall Street" in the NBC Nightly News broadcast. The Wall Street Journal led its Friday paper with this headline: "Dow again soars to record high despite unease".

Technically, all the talk about records is perfectly accurate. But it's also fundamentally wrong. In fact, the attention that's being showered on "Dow 14,000" goes a long way towards explaining why our economy has become so susceptible to speculative bubbles.

The idea stock prices tend to rise over time really should not be surprising. The price of almost everything rises over time, thanks to inflation. Each year, the government prints more money, which is the main reason that the price of groceries, cars, clothes and, yes, stocks keeps on going up. Of course, incomes are rising, too.

This doesn't mean, however, that everything is always getting more expensive and everyone is always getting richer (which would be a contradiction). And the sharemarket's record high does not mean that stocks have been a wonderful investment lately. They haven't been.

The Standard & Poor 500-stock index, which is a much better measure than the Dow, closed Thursday at 1553.08, just 1.4 per cent higher than the peak it reached in March 2000. Think about what that means. While the price of nearly everything has risen over the past seven years, stocks have barely budged. They have only marginally outperformed cash sitting in a bureau drawer. So if we are going to talk about a sharemarket record, we should be doing the same for a whole lot of other things: "Loaves of bread surge to new highs".

This can sound like statistical nitpicking, but it actually relates to something quite important. When you overlook inflation, you can start to think that every investment is a can't-miss investment, because its value always seems to be going up. This mistake, combined with the enormous attention that society now devotes to the value of its investments, helps create the conditions for a bubble.

A few years ago, I was interviewing a US real estate agent in the Midwest, and she mentioned that her daughter had recently sold her house for 30 per cent more than she had bought it for a decade earlier. "Where else can you get a return like that?" the agent asked. One answer, which I didn't give, is a boring old savings account.

The only meaningful way to measure an investment is to strip away the distortions caused by inflation. You're then able to focus on its real value - what it can buy in the marketplace - rather than just a number on a piece of paper.

A good rule of thumb is that something appearing to have doubled in price or value since the early 1980s costs the same now, in real terms, as it did then. When you make these adjustments, it becomes disturbingly obvious that stocks and real estate are by no means can't-miss investments.

The average house in the New York region sold for roughly the same nominal price in 1997 as it had in 1988, which in inflation-adjusted terms means its value dropped 31 per cent. House prices in New York didn't exceed their 1988 real value until 2002. Then, of course, they soared like never before.

The sharemarket has suffered through even longer stretches of mediocrity. The S&P 500 first went over 100 in the summer of 1968. In today's dollars, that means it was up near 600. It then entered a long period in which it failed to keep pace with inflation - leading to BusinessWeek's famous 1979 cover article, "The death of equities" - and didn't exceed its real 1968 high until 1992. Over the next eight years, it tripled, even after taking inflation into account.

Today, the S&P remains 17 per cent below its inflation-adjusted 2000 peak, which could be considered good news. If the market isn't really at a record high, it may still have a lot of running room. But I wouldn't be too confident about that. Relative to their earnings, stocks remain more expensive than they have been at any time except the 1920s and the 1990s.

That's the thing about bubbles: they usually take a long time to overcome. The normal pattern after a huge boom - like the sort we recently had in stocks and then real estate - is years if not decades in which an investment doesn't keep up with savings accounts. That's not so much of a record.