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Bad Weather Ahead?

The forecast calls for the cold and stormy June to resume here in the middle of this vast continent after a brief heat wave. We’ve come to rely on weather forecasters to at least give us a guess as to what it will be like as the lazy days demand outdoor fun. Tomorrow night, for example, they tell us there is a 25% chance of rain.

But such forecasts are usually limited to the weather. Why not stocks?

The short answer is that when there’s a lot of money riding on something a busted forecast could be cause for a lawsuit. No one wants to stick their neck out too far beyond the herd because anything unprecedented is a risk not worth taking. But we’re here among friends, right? Barataria makes forecasts from time to time and this month is a good one for it. The reason is that we can see a storm brewing as stocks have gotten pretty far ahead of the “recovery” so far.

Today's bears are not irrational.

Today’s bears are not irrational.

To start with, June is usually a terrible month for stocks. It’s also a terrible month for the economy, as everyone goes off on vacation. Thanks to “seasonal adjustment” we have data that accounts for this, whether it’s a good idea or not. But what we do know in the non-seasonally adjusted stock market is that June has been down an average of 1.32% over the last 15 years.

This year is especially perilous, however. The Federal Reserve is likely to raise the benchmark Fed Funds Rate soon, and possible when the Fed Open Market Committee meets on June 16-17. Wall Street has been betting heavily that no, they won’t raise rates yet. But what if they do?

Let’s go out on a limb and say that the odds that they will raise a quarter point (0.25%) are about 50-50. Even if they don’t raise it we can reasonably expect some forward guidance that it will indeed jack up rates soon.

Wall Street has been betting heavily that this won’t happen for reasons that don’t really make sense. We do know that a solid third of all traders in the high-burnout profession have never worked in a world with a Fed Funds Rate above zero, which partially explains it. But there is a general feeling that if the Fed raises rates the market will tank and the Fed doesn’t want to do that. There is a serious flaw in this logic, however.

Panic doesn't help anyone.

Panic doesn’t help anyone.

When the rate does go up, and it has to eventually, the market will respond badly. So whether it happens now or later really doesn’t matter that much.

In such a climate, why should the Fed pay any attention to Wall Street at all? If anything, there is something to be gained by performing the dirty work sooner rather than later in order to show ‘em all who’s boss. So why not now? Why not make a statement that it’s about time for the Fed to take control?

By contrast, however, the economy is not producing the jobs needed and consumer spending is very weak. There are a lot of reasons to not introduce a rate hike shock to the system now. We don’t have the latest update on Yellen’s Dashboard for 2Q15, but it’s not as strong as anyone would like. But there has been progress since the Fed Funds Rate hit zero in 2009 and there is no reason to continue that policy now.

A storm is brewing?

A storm is brewing?

If you can accept the chances of a rate hike this week at 50%, we then have to move on to how the market will react. Again, everyone knows that June is a bad month. But everyone is betting on no action from the Fed to guide us through a quiet summer. What if that doesn’t happen?

It seems reasonable that a rate hike, whenever it comes, will be taken as a surprise. The possibility of a panic of some kind is at least likely.

Let’s just say that a temporary period of irrational fear lasting a few days or a few weeks is, again, a 50% chance. That’s reasonable given how inexperienced the Street has become and how much they are banking on no rise soon. Anything that catches them off guard is always a problem. By “panic” we can say a drop of 5-10%, with the possibility of a big recovery shortly afterward. That’s nothing long lasting, but it could mean a giveback of the gains of the last year.

Put together, we have a 25% chance of a serious storm washing over Wall Street in the next few weeks. Those odds are more of an estimate than a promise – they are exactly like the weather forecast. Like any approaching storm, you may reasonably want to bet that it’s not going to happen given that it’s less than what we’d call “likely”. But if it does come things will be nasty.

That’s the prediction for the next few weeks. Partly cloudy and a chance of a thunderstorm.

4 thoughts on “Bad Weather Ahead?

  1. I put the odds of both events much higher, maybe 2/3. That gives 44% overall for a panic. Good blog.

  2. Pingback: Stock Panic? | Barataria - The work of Erik Hare

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