I explained my methodology (in a 2014 article) that broad stock indices like Dow or S&P reflect the purchasing power of the middle class of America. Purchasing power changes based on disposable income, which is the money left from wages after paying for basic needs like food, fuel and home. I have been writing one article almost every year since 2009 predicting the stock market for that year, based on this concept of disposable income. So far, the predictions have never been wrong. An increase in purchasing power occurs when wages go up and interest rates go down, and decreases when inflation is higher, gas prices are higher and home prices are higher. This formula does not take into account a feel-good factor caused by an increase in home equity for home owners, or rare incidences like war or terrorist activity.

First, a reflection on my past predictions based on the disposable income concept/formula:

Here are my estimates for these factors in 2018:

Wages

Fed Chair Jerome Powell recently stated that he is not sure why wages are not picking up despite unemployment being very low. President Trump’s agenda of making America great again cannot be realized for the middle class Americans by simply deregulating and lowering taxes for the corporations. Corporations have been using all possible tactics to avoid paying taxes as well as avoid paying decent wages to American workers. Some of the well known tactics are outsourcing jobs to contracting companies, offshoring jobs to foreign countries, hiring contractors instead of full time workers, hiring for only short term tasks and getting rid of employees as they are older. Due to these reasons, wages will not go up dramatically despite low unemployment. I estimate wage growth of maximum 5% this year.

Tax changes

For most middle class Americans, new tax brackets are 2% lower now compared to last year and standard deduction is higher. However, there has also been elimination or reduction in deductions like state taxes, property taxes, commuting expenses and home equity interest charges. Further, sale of home would not be capital gains tax free if done in less than 5 years compared to 2 years earlier. Home equity which helped people fund many of their purchases are not always tax deductible now. Therefore, I would just add 1% to the take home wages as the overall impact of the new tax law.

CPI

Due to higher import prices owing to lower dollar plus a higher demand in a growing economy, CPI has increased around 1.5 % in just the first 3 months of this year. By the end of this year, I expect it to grow nearly 6%.

10 year Treasury

As the Fed has made it clear, due to low unemployment and higher inflation, interest rates would continue to go up. The 10 year treasury is already 2.9% and 30 year mortgage rates are 4.4%, which are quite high and 60 basis points higher compared to just a year back. I expect the 10 year treasury to be around 80 to 100 basis points higher compared to beginning of the year by the end of the year.

Home Prices

Despite upbeat headlines by real estate industry, the inventory of new rental properties is so high in certain markets like New York, that rents have actually gone slightly lower. With high mortgage rates, new property tax and mortgage interest deduction rules and difficulty in using home equity to purchase an investment property, I expect many small investors to exit, so home price increase should be minimal. I give it approx. 2% by the end of the year compared to the beginning of the year.

Gas Prices

As of today, gas prices are higher by 15% in 2018. President Trump recently made angry comments on higher gas prices. I would use 20% as the gas price increase in my calculations here.

S&P increase /year = 20.2

+3.4* percent increase in Wages

-3.4 * percent increase in CPI

-0.8 * percent increase in Home prices

-0.5* percent increase in gas prices in first 4 months of the year

-1.4 *(percent increase in home prices * percent increase in ten year yield )

-7.4 *(percent increase in ten year treasury yield * percent increase in ten year treasury yield )

So the disposable income formula suggests that by the end of this year, the stock market could be 2% higher or 2% lower than the beginning of the year; either way, the S&P should be lower than its January 2018 peak of 2872.