The Misery Index is Causing Trouble Again

Growing up as a child in the 1970s, I occasionally overheard adults speaking of the gloom and doom that had overtaken the U.S. economy.  From my child's viewpoint I could see that these adults were pessimistic and angry, and I was led to think the "Glory Days" for the U.S. were a thing of the past. Little did we know that things would soon get better, and by the 1990s much, much better.

Well, if a widely-tracked measure is any guide, we may be headed for another era of 1970s style gloom before we can once again speak of a "Dawn in America." That measure: the Misery Index, which combines the unemployment rate with the inflation rate. In 2010, that index hit its highest level since 1984. And prospects for a pullback in this index are starting to dim. Here's why.

It may seem arbitrary, but any reading above 10.0 can seem quite painful to the U.S. economy. That means that either inflation or unemployment is too high for consumers to feel comfortable.

In the 1970s and early 1980s, inflation was at its highest levels of the 20th century, and it didn't help that unemployment rates seemed stuck in upper single digits.

Since then, we've seen inflation fall steadily in tandem with a jobs boom. The Misery Index hit a modern era low of just 6.05 in 1998, which perhaps should be called the Happiness Index. That era of good feelings may help explain the meteoric rise in the stock market in the late 1990s.

Although the Misery Index remained in check well into the last decade, it has started to tick up again.

A reading of 11.3 in 2010 means that consumers are again feeling the pain. But this time is different. Instead of the rampant inflation of the 1970s, we saw the highest rate of joblessness in 2010 since World War II.

The good news, unemployment is starting to come down. The bad news: Inflationary pressures may be returning to the economy, which promises to keep the Misery Index above 10.0 in coming years.

Either One, But Not Both

The U.S. economy indeed appears to be on the mend. But due to a variety of factors including our nation's large national debt, extremely loose monetary policy, and emerging shortages of key commodities as diverse as copper and wheat, a rebounding economy is expected to see the return of price pressures. In effect, falling unemployment, which helps boost the economy's pace, creates the very pressures that support inflation trends. So an increasing number of economists believe that the unemployment rate will fall a full percentage point in 2011 and again in 2012, offset by the opposite move in inflation.

To break it down by the numbers, the unemployment rate stands at 8.8% and the inflation rate stands at 2.7%, yielding a current Misery Index of 11.5. For the Misery Index to fall below the psychologically important rate of 10.0, the unemployment rate would need to fall below 7.0 while inflation remains largely in check. That could happen, but recent trends such as a move to $110 (per barrel) oil and $4 (per gallon) gasoline argue that a wide range of companies and consumers are seeing rising costs. Inflation bubbles up when higher costs force producers to raise their own prices, setting off a vicious cycle of price hikes.

So what does this mean for stocks? Well, if history is any guide, it can't be good. The Misery Index was above 10.0 throughout the 1970s (except for 1972). In that time, the S&P 500 rose 34%, or less than 3% a year, on average, which of course, badly lagged inflation, and was thus quite negative in real terms. (Adding insult, all of the S&P 500's gains came at the end of the decade, which meant stocks went nowhere for seven straight years.)

Conversely, a low Misery Index in the 1990s was great for stocks. The S&P 500 rose 223% in that decade, or roughly 13% a year, well ahead of the rate of inflation. It's not comforting to note that the S&P 500 has doubled in the last two years, even as the Misery Index has started to move higher.

This all adds up to a warning sign for stocks. If inflation can remain in check, and the Misery Index can move back below 10.0, then stocks have a clear shot of moving yet higher. But unemployment that is still too high, coupled with the recent surge for items like oil and agricultural products, means that consumers' misery looks set to continue.

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