My Two Cents - "Nominal Bulls vs. Real Bears"

1/12/2007

For the past two weeks, we have heard how robust the stock market was in 2006. Proclamations about the 2006 bull market are as common as snow in Colorado it would seem. However, a rather interesting undertone has developed parallel to these proclamations for continued rabid growth. The average person isn't seeing it. The gains aren't impacting them the way they should be or even for that matter the way they have in the past. I see this undertone developing as a result of the fundamental misunderstanding between nominal and real.

The misunderstanding stems from the fact we no longer engage in a direct exchange economy or as is more commonly known a barter system. Under the rules of a barter system, people engaged in trade based on their own perceptions of the value of the good given up and the good received. People would not trade for something they didn't need just because they wanted to get rid of something else. On an individual basis, barter was useful, but in a complex economy, it doesn't pan out as well. When economies become more complex, moneys are often created to serve as media of exchange with all goods and services denominated in terms of the applicable money. In the United States, we use dollars to denominate the 'prices' of goods and services. This concept would work superbly if the dollar were of constant value. However, as history shows, such is not the case.

Using the comparison of the barter system (direct exchange) vs. the dollar-denominated system (indirect exchange with money), the direct exchange value of something is the real value. For example, if you traded a bushel of corn for a pair of shoes, you could then say that the real value of one pair of shoes was one bushel of corn. Also, if you traded 20 dollars for a pair of shoes then you could say that the real value of one pair of shoes was 20 dollars.

If, however, over time the value of the dollar became diluted and when you bought your next pair of shoes, you had to pay 30 dollars instead of 20, but another person was still willing to trade you the shoes for the same bushel of corn, you could say that the real value of the bushel of corn was constant (one pair of shoes), but that the value of the dollars had fallen by 50% since it took you 50% more dollars to purchase the same item.

In the above scenario, the nominal value of shoes went up 50%, but the real value of the shoes expressed in something tangible was constant.

Such a situation existed in 2006 with the stock market. I am going to provide numbers, some of which are based on my own personal situation; feel free to plug in your own information. The Dow Jones Industrial Average rose 16% in 2006, priced in dollars. However, priced in food, the DJIA was down 4.8% (Food increased 21.8%, DJIA up only 16%). Priced in utilities, the DJIA was up .4% Priced in gold, the DJIA was down 7%, and priced in silver, the DJIA was down 29%. The take-home point is that it doesn't matter that the DJIA was up 16% if the costs of everything else was up that much along with it. The nominal gain is there, but the REAL gain is nowhere to be found. People have been trained to look at nominal values not real values: what the gains will actually buy. If the gains can't purchase anything, then they aren't really gains are they?

What each person can do is keep careful track of their expenses and figure out the y/y percent change. Be careful though not to count buying a pleasure car as an added expense though. I'm talking about staple goods and necessities like food, energy, healthcare, education etc. Weigh the changes in your expenses against the paper gains your investments. If your investments outpaced gains in your expenses, that's a good start. If not, then you really don't have gains in real terms. Based on the conversations I have had with people, this is where most of the problem lies. People see a gain in their investments, but end up having to cut back on expenses or even take on debt just to maintain their standard of living.

If you get in the habit of looking at things in real terms as opposed to nominal terms, not only will you better understand your financial position, but you will be able to see through the mainstream press' party line as well. In the end, it also explains the bull-bear debates seen so often on TV recently. The bulls generally look at things in nominal terms, while the bears focus on what's real. It ties into an old saying of mine: "You can't eat stocks". In this case, you can't eat nominal.

The Author holds an MBA in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics.

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