How to set pickup height properly
There are 2 ways to do this. I'll be explaining both.
Method #1: Height of the fretboard
Adjusting the pickup height to match the fretboard does work on many guitars, provided there are no pickup rings getting in the way.
While not "correct" to some, it is the fastest way to get the job done.
Method #2: Wound string side down, plain string side up
This is the method I use personally, pictured above. You'll notice the pickups are leaned where the height is adjusted lower for the wound strings and higher for the plain strings.
This is the method most players consider "correct".
For pickups with greater magnetic pull, the wound strings when plucked will produce a warble-like sound if the pickup is set too high. If for example you play your 6 (low E) string on the 12th fret and hear a warbling noise, as if two notes were playing at once slightly out-of-tune with each other, the string is too close to the pickup and needs to be backed off.
How much lean is necessary for method 2?
This is where things get interesting.
Pickups described as having "vintage" output indicates low output, meaning not too much lean is necessary to avoid the warbling sound on the wound strings.
Pickups described as "hot" indicates a high output, meaning more lean on the wound string side is necessary since the magnetic pull is greater.
A few words about alnico magnets
Where alnico magnets are concerned, the higher the number, the greater the magnetic pull. The most common is the alnico 5, followed by alnico 3. The least common is the alnico 2. Remember, alnico is not a company but a description of the magnet materials aluminum, nickel and cobalt (take the first 2 letters of each and that spells alnico).
Where Squier guitars are concerned, alnico 5 magnets can be found in the Squier Classic Vibe '60s Stratocaster and alnico 3 in the Squier Classic Vibe '50s Stratocaster. And yes, that does mean the '60s Strat has a greater output compared to the '50s. That doesn't make the '60s any better nor worse than the '50s. It's just a different output.
Generally speaking, most players like alnico 5 because it has the "hottest" output. But that means you have to lean the wound string side of the pickup down a fair amount to get rid of the warbling sound.
While using alnico 3 or 2 means you can raise the wound string side of the pickup higher, the tradeoff is that most of the time you lose treble response compared to an alnico 5.
What about pickups with ceramic magnets?
Adjust the pickups the same as you would for alnico. If you hear warbling on the wound strings when fretted at the 12th, lower the pickup it until the warbling sound diminishes enough to your satisfaction.
What else happens if the pickups are set too high?
Tuning and intonation issues.
On an audio-based tuner (as in one you plug into), a warbled note will always be fluctuating, making to-the-note tuning almost impossible.
With intonation, the same applies. Warbled notes result in making it very difficult to intonate the guitar.
"I don't get enough pickup response when my pickups are set lower to avoid the note warbling. What do I do?"
Know that you don't have to "max out" a compressor. Light compression is just fine to get that extra boost and punch when playing clean, overdriven or distorted.