Although the Kabuki Dance in Washington is grabbing all the headlines, the stock market will ultimately be driven by earnings, inflation and interest rates. Stock values go up when earnings rise and go down when inflation and interest rates rise. So let’s see what our Investment Climate analysis, shown below in the “Climate” section of these Views, is telling us about these three critical factors.

To quote CNBC’s Larry Kudlow, “Earnings is the mother’s milk of the stock market.” We use a 50-day moving average of S&P500 EPS as shown in our S&P500 WatchList to track earnings. The current level of this value is $4.01 per share and its earnings trend on a scale of 0.00 to 2.00 is 1.07, which is favorable. We consider the Investment Climate to be Bullish as long as this indicator is above 1.00. This analysis deserves special attention so we report on it every week in the Investment Climate report. For more information, please read my essay of October 13, 2006.

Ironically, the current level of the earnings trend indicator is 1.07, exactly what it was on October 13, 2006. Then, as now, earnings are forecasted to grow at a slower rate, but don’t break into a cold sweat. This indicator moves slowly and we will keep you informed.

VectorVest tracks three measures of interest rates. These are: 90-Day T-Bills, 10-Yr. T-Notes and 10-Yr. AAA Corporate Bonds. The current level and trend of each of the rates is calculated every week. The current average of these three interest rate trends is 1.44. Therefore, interest rates are deemed to be falling.

You should be aware that on Wednesday, Dr. Ben Bernanke, Chairman of the Federal Reserve Board, reported that the Fed would begin to use both inflation and unemployment targets to help set monetary policy. Specifically, he said they would keep short-term rates near zero until the unemployment rate falls to 6.5% and inflation is forecast to reach 2.5%. They don’t expect these conditions to arise until mid-2015.

In regard to inflation, the Labor Department reported today that the Consumer Price Index, CPI, rose 1.8% year-over-year in November. This rate is down from October due to lower gas prices, but our CPI trend indicator is at an unfavorable level of 0.86, which means it is rising.

Dr. Bernanke alleges that inflation will remain low for years to come. Maybe so, but he is playing a risky game by flooding the world with money at extremely low interest rates. Unless America turns into another Japan, rampant inflation will eventually rear its ugly head and stock values will drop like a rock. So we need to watch this indicator very carefully.

The Commodity Research Bureau’s Price Index, CRB, is a leading indicator of inflation trends. At a current level of 292.70 it is very close to its 40-week moving average and trending higher from a recent June 2012 low of 268. Therefore, its trend indicator is unfavorable at 0.92. With earnings and inflation rising while interest rates are falling, we currently have a Case 1, Bull market scenario. For more information on these scenarios, please see the Views of 03/21/2003, 03/28/2003, 10/24/2003, 09/29/2006 and 10/13/2006. You may see graphs of the Investment Climate indicators by clicking on the Graphs tab and clicking on Market Climate. It will be interesting to see how the Kabuki Dance unfolds through the lens of the Investment Climate Indicators.