Opinion: This one gauge will tell you where the stock market is heading – MarketWatch

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Barring a drop in the stock market because investors lose faith in President Donald Trump, here’s what you need to watch to understand whether the market continues higher from here:

• How much you and your friends get in pay raises

• How much you pay for things

Trends in these areas could give you a heads up on the biggest potential market killer out there: Inflation.

But aren’t Fed rate hikes the big problem for stocks? After all, we’ve had three interest-rate hikes since the 2008 financial crisis. The old Wall Street adage “three steps and stumble” tells us this is the time to be nervous. According to this rule, stocks run into trouble after the third Fed rate hike coming out of a recession.

And three may just be the start this time. The Fed is likely to hike in June and again later in the year. Moody’s Analytics chief economist Mark Zandi expects three to four 25-basis point rate hikes a year for the next few years.

This sounds ominous for stocks. But in this investing climate inflation is a bigger risk, according to recent research by Jim Paulsen, an economist and market strategist with Wells Capital Management. Here are two reasons.

1. It’s all about attitude

While so many people cite “three steps and stumble,” the fact is the adage doesn’t always hold true. Sometimes three or more rate hikes tank stocks. Sometimes they don’t. It all depends on what investors fear most at the moment — inflation or deflation.

History shows that when investors are worried about inflation, rate hikes can tank markets. But when they’re worried about deflation (as they have been for almost 10 years and still are), the stock market can do just fine as rates rise.

How do we know that investors are worried about deflation?

For starters, just read the financial press. For years we’ve heard from the doom-and-gloom crowd that we are all in trouble and stocks are a terrible investment because the economy is on the verge of a “deflationary abyss.” Deflation is scary because it stifles growth as people put off purchases, expecting lower prices. It also hurts banks because they get paid back in cheaper currency.

The stock market is up about threefold since the doom-and-gloom crowd started this rant in earnest in late 2008 and early 2009. But the financial meltdown was so severe that deflationary angst became deeply ingrained and is still with us.

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Here’s the other way you can tell whether investors are worried about inflation or deflation: Look at the correlation between stock prices and bond yields.

When stocks rise as yields rise, it tells investors fear deflation. This is just another way of saying that in this scenario, signs of better growth and inflation — and the Fed rate hikes that flow from that — spark little fear among investors that the economy is overheating. Instead, they’re actually relieved that deflation seems more distant. So they buy stocks. That’s what’s happening now.

In contrast, when investors sell stocks as rates rise, they’re worried about an overheating economy and inflation. That was the case for most of the 1980s and 1990s.

The bottom line: As a stock investor, you need to be very wary of signs of growing inflation. That will get investors worried about inflation again. In this scenario, rising rates will hurt stocks.

We’re not there yet. But keep an eye on pay hikes and what you pay for things for signs that this might be changing. “Until the attitude among investors shifts from deflation to inflation worries, rising yields and Fed tightening may continue to be met with a resilient stock market,” says Paulsen.

2. Valuations matter, but maybe not as much as you think

Besides Fed rate hikes, another big worry among investors now is the market looks fully valued. The S&P 500 SPX, +0.55%   has a trailing price/earnings ratio of around 25. But this looks less scary if you consider the context — and here again inflation is the key.

Consider the “misery index.” Popularized during the stagflation years of the 1970s, the misery index is simply the unemployment rate plus the inflation rate. A higher number means more misery, because people earn less after adjusting for inflation but pay more for goods and services.

But here’s the key to the misery index for stock-market investors: Since the 1960s, it’s had a tight inverse correlation with market valuations. When the misery index was sky high, like in the 1970s, the stock market P/E was very low. In contrast, when the misery index is low (like now) the stock market P/E ratio can remain high and move higher.

In short, today’s high market valuation looks OK. This makes sense intuitively because if most people are employed and inflation is low, consumers spend more, which supports growth. That boosts earnings, and investors will pay up for stocks.

As long as the misery index remains low, P/E valuations can remain high, and the market can rise in line with earnings growth from here.

Once again, inflation is the key here. Unemployment will probably remain low since it doesn’t look like a recession is on the way. Any immigration controls will tighten the labor market even more. This tells us the only thing that could bump the misery index higher — and threaten the market — is higher inflation.

“Relative to the misery index, the stock market does not currently appear overvalued,” says Paulsen. “If anything, relative to Main Street misery, it may be a bit undervalued.”

The bottom line: As long as the misery index remains low, P/E valuations can remain high, and the market can rise in line with earnings growth from here. Typical earnings growth, plus dividends, suggest 5%-7% annual gains from here.

The outlook for inflation

if it all comes down to inflation, here’s the key question: Where are prices heading next? No one knows for sure. But inflation might not be a problem for the following reasons, says Ed Yardeni, president of Yardeni Research.

• Technology advances are putting downward pressure on prices. Worries among workers that computers, artificial intelligence and robots can take their jobs may explain why they aren’t aggressively asking for higher pay.

• The retail sector is incredibly competitive, thanks in part to Amazon.com AMZN, +1.60% and this is putting downward pressure on prices. Globalization also puts downward pressure on prices, though this may change to some degree under Trump.

• Ongoing advances in fracking will keep boosting the supply of oil and natural gas, which will limit the odds of runaway energy costs.

• The strong dollar puts downward pressure on U.S. prices. It limits the impact of foreign demand on the U.S. economy and makes foreign goods more competitive compared with those made at home.

One worry is that Trump wants to dramatically increase military spending without significantly cutting the rest of the budget. This will lead to an overall increase in federal spending, aka “fiscal stimulus.” At any point in time fiscal stimulus can be inflationary — particularly so when there is full employment. But Yardeni doesn’t see this as a huge risk, given all of the other forces putting a lid on price hikes. So he forecasts 2% inflation a year for the next few years.

Zandi of Moody’s Analytics is looking for a little bit higher inflation due to the tight labor market, higher rents and rising health-care costs. He expects inflation to rise to 3% by early 2019.

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Neither of these forecasts look too troubling. Paulsen estimates inflation could rise to 3.5% (assuming unemployment stays low) before the misery index gets high enough to trim stock valuations, given the historical correlation between the two.

Right now, it doesn’t look like we are going to get to 3.5% inflation any time soon. But it’s a whole new ballgame with Trump in office. So watch those paychecks, how much you pay for stuff and the reported inflation data for an early read on whether these economists are about to be proven wrong.

Michael Brush is a Manhattan-based financial writer. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested AMZN in his stock newsletter Brush Up on Stocks.

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