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Felix Salmon links to a chart by DeForest McDuff of the S&P 500 priced in eggs. McDuff writes:

Investment returns matter only to the extent that you can buy more "stuff" in the future. The U.S. stock market has been slowly losing real purchasing power for almost a decade, with no signs yet of a trend reversal.

It's true that the prices of hard assets like oil, gold, and omelettes have been increasing rapidly, but this is a direct consequence of decades of underinvestment in these asset classes. If you're not thinking about investing in terms of purchasing power, then you're playing the wrong game.

This is correct, however, I caution against looking at the stock market in the price of some commodity. This is a subtle but important point. A lot of financial analysis involves developing a “feel” for the numbers.

The problem of pricing the market in terms of some commodity is that it often involves two data sets with very different characteristics. Equity prices are tied to corporate profits and therefore cyclical. At least in theory. Commodity prices, however, are often marked by price disruptions, meaning dramatic price spikes. If you look at the long-term chart of nearly every commodity, you’ll see a few large spikes followed by long periods of not much.

That’s why when you compare stock prices to a commodity, it often tells you less about equity prices and more about the commodity. From my experience, the most often used example is gold. For the last 35 years, the prices of gold has been a wild ride from around $30 to over $800 back to $250 and then up to $1,000. The stock market can be wild but nothing like that. Also, gold doesn’t pay dividends where the market does. It may not be much each quarter, but if you’re looking at a chart going back a few decades, it does add up.

Think of it this way. A commodity is a thing. In 1,000 years, gold will still be gold. But equity is what you do with the thing to make money. If you make enough money, you can buy more things. A stock can own a commodity, but a commodity can’t run a business.

Posted by edelfenbein at July 8, 2008 1:31 PM