These days most investors seem bearish. People are worried about slowing growth and/or rising inflation, and are extremely circumspect that the Fed can pull-off a soft landing. This is possible. One can look at fundamental reasons (slowing housing market, tapped-out consumer, energy inflation feeding into core inflation, rising inflation expectations...) to feel gloomy about the world's economic future.
However, the sequence in which events unfold will have as much bearing as what events actually do unfold. That is, if inflation slows before growth stalls, the stock market reaction would be very different than if growth were to stall before inflation softens.
In this context, perhaps the single biggest factor that will determine the direction of the stock market over the coming 3 months will be the next 3 weeks of the hurricane season. Let us explore this thesis in more detail below:
A) Hurricane Season: Oil prices have remained at elevated levels the past couple of years over geopolitical concerns and the extensive damage caused by hurricanes in the Gulf of Mexico region. So far this year, hurricane activity has been quiet — only 3 named-hurricanes so far vs. 10 last year. Mid-August to mid-September is peak season for hurricane activity, of which two weeks have already passed. If, and this is a big if, the season were to pass without any major incidents in the Gulf of Mexico reason, oil prices could be headed down sharply — towards $65 and maybe $60.
A quiet hurricane season will help in two ways: First, it will remove some of the supply-disruption risk inherent in current oil prices. Investors will realize that massive oil inventories have built-up over last year; more than enough to sufficiently address demand. Second, it will give the oil-infrastructure in the Gulf of Mexico region one additional year to recover from the battering it received from Katrina and Rita. This will further depress prices.
While considering headline risks, I don’t think the nuclear-standoff with Iran will result in a oil trade-embargo for 3 reasons: First, China and Russia will not support it. Second, Iran wants to reap benefit of $70/barrel oil. The last time Iran had an oil embargo, in 1952 (imposed by Great Britain), the country faced severe economic difficulties. Iran will posture, and get maximum concessions out of the UN, or perhaps the UN will slap some sanctions on Iran. And third, I doubt the Bush administration will risk $90 oil in an election-year when Republican prospects look shaky. If Bush does something on Iran, it will be in 2007.
B) The Fed: One can safely assume the Fed will not raise rates in September just 6 weeks after it stopped. August's core CPI of 0.2% bolsters this scenario. If oil prices start falling in mid-September due to the lack of hurricane damage, it will give the Fed further reason not to raise rates in its next meeting in October. The Fed will argue (in October) that a falling housing market is curbing demand and reducing inflation, and falling energy prices are further restraints to inflation.
C) Stock Market Reaction: If oil prices fall, helping the Fed remain firm in its stance, markets will rally. Investors will become less worried about consumer demand in the all-important holiday season, and visions of goldilocks may again emerge.
This is not to say that it will be an all-clear signal for 2007. A falling US housing market, resetting ARMs, the falling US dollar, etc. pose their own risks. But until Thanksgiving, we could get a 8%-10% rally in the stock markets, if the hurricane season will only leave us unharmed.