Why markets could spike in the next 3 months.

These days, most investors appear bearish. People are worried about slowing growth and/or rising inflation, and extremely circumspect that the Fed can pull off a soft landing. That is possible. One can look at fundamental reasons (slowing housing market, tapped our consumer, energy inflation feeding into core inflation, rising inflation expectations - at least in University of Michigan survey) etc etc to feel gloomy about the future of the world.

However, the sequence in which events unfold will have as much bearing on what events actually ultimately 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 next 3 months could well 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 in the last couple of years on geopolitical concerns, and the extensive damage caused by prior year hurricanes in the Gulf of Mexico region. So far this year, the hurricane activity has been quiet - only 3 named hurricanes so far vs. 10 last year. The period from Mid-August to Mid-September is the peak season for hurricane activity, of which one week has already passed. If, and this is a big if, this season were to pass without any major incidents in the Gulf of Mexico reason, oil prices would be headed down sharply - towards $65, and maybe $60.

For, a quiet hurricane season would help in two ways. First, it would remove some of the supply disruption risk in the current oil prices. Investors will suddently realize that massive oil inventories have built up over last year to sufficiently address demand. Second, it would give the oil infrastructure that is still out in the GOM region one additional year to recover from the battering it received from Katrina and Rita. This additional supply would further depress prices.

While posing headline risks, I don’t think the nuclear standoff with Iran would result in a oil trade embargo for 3 reasons. First, China and Russia would not support it. Second, even Iran would not want not to reap benfits of $70 oil. The last time Iran had an oil embargo in 1952 (imposed by Great Britain), the country did face severe economic difficulties. Iran would posture and get maximum concessions out of the UN, or the UN will slap some sanctions on Iran, but I doubt Bush administration would 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 Moves: One can safely assume that the Fed will not raise rates in September just 6 weeks after it stopped raising rates. August core CPI reading of 0.2% bolsters this case. If oil prices were to start falling in mid-September because of no hurricane season impact, it would give the Fed reason not to raise rates in its next meeting in October. For the Fed will argue (in October) that a falling housing market is curbing demand and reducing inflation, and falling energy prices are further restraining inflation.

C) Stock Market Reaction: If oil prices were to fall, helping the Fed remain firm in its stance, markets would rally. For investors would become less worried about consumer demand in the all-important holiday season, and a hope of Goldilocks might emerge again.

This is not to say that it will be an clear signal for 2007 - falling US housing market, resetting ARMs, falling US dollar etc - pose their own risks. But, till Thanksgiving, we could get a 8%-10% rally, simply if the hurricane season were to leave us unharmed.