A Walk Down Memory Lane: Thoughts on HPIs and Financial Indexes as The Dow Celebrates Its 120th Birthday

On May 26th, 2016, the granddaddy of all equity indexes—the Dow Jones Industrial Average (DJIA)—turned 120.  The 30 blue-chip companies that comprise the DJIA have evolved over time –General Electric is the one that has been in the index the longest, since 1907–and today many are no longer in heavy industry.  Nonetheless, the DJIA remains a gauge of equity-market performance.

Few sectors of the economy have indices that trace activity for more than a century.  In the housing market, one can merge various metrics and survey data to develop a house-price index that stretches back to 1890, before the inception of the DJIA.  Professor Robert Shiller has done just that, splicing together the S&P CoreLogic Case-Shiller Index beginning 1975 with pre-1975 price data. [1]  And even though the geographic composition of prices has not been constant over that period, neither has the composition of the DJIA.

By taking the ratio of the DJIA to Prof. Shiller’s house-price series, and setting the ratio to 1 in 1896, we can compare how the DJIA and home prices have compared (Exhibit 1).  For much of the first half century, equities and home values largely moved together, with the exception of the “roaring ‘20s” that preceded the Great Depression.  Even as recently as the early 1980s, equity values had cumulative growth that was only slightly more than home values.  Since then, however, equity values have soared relative to home values, increasing several fold compared with home-price indexes.

While the valuation gain on equities (rather, on the firms that comprise the DJIA) has exceeded the price gain on houses, equities also have more risk.  A general principle is that investments that have more risk should also compensate the investor for holding that risk.  A true investment ‘return’ would reflect both valuation gain and income earned from the asset over time (for example, dividends or rent) and net out any costs (such as home improvements), but for simplicity we can compare the valuation change with volatility over time:  While equity values have grown more than house prices since 1896, the annual volatility in the equity market has also been far greater than the volatility of house prices (Exhibit 2).[2]

That’s not to say that house prices are not volatile; the boom-bust cycle in housing over the past decade has shown that house prices can have significant year-to-year movement, both up and down.  And while house prices have not kept up with stock values, homes appear to have held up well relative to general inflation:  Since 1913,  the inception year for the Consumer Price Index, house prices have grown about 0.5 percent per year faster than inflation.[3]

Financial advisors caution that past performance should not be used as a gauge of future returns.  While the past century cannot foretell the valuation trend of the next, at least two outcomes are likely over the next 120 years:  First, equity values will likely grow more than home prices but with more volatility; and second, housing will generally be a good inflation hedge for owners with long holding periods.

[1] See http://www.econ.yale.edu/~shiller/data.htm

[2] For the analysis, the month-end values of the DJIA were averaged to produce an annual time series; for 1896, the annual average was computed over May to December, and for 2016 the average was computed over January to June.  Likewise, the annual average of the monthly S&P CoreLogic Case-Shiller Index for the U.S. was computed beginning 1975 (the 2016 average was computed for January to June); this was used with Prof. Shiller’s pre-1975 data to form an annual time series back to 1896.  The compound annual growth rate and annual volatility in Exhibit 2 were computed from the two annual time series.

[3] Compound annual growth rate, Prof. Shiller’s Nominal House Price Index and the Bureau of Labor Statistics’ Consumer Price Index-All items, 1913-2016.

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