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Cramer's Fed cheat sheet: Prepare for 6 pitfalls

In Jim Cramer's opinion, the market rallied for all the wrong reasons on Tuesday, such as weak U.S. manufacturing data and the brutal decline in the Chinese stock market. Has the market completely lost its mind?

No—but bad news is good news right now.

This is because the uglier that the economic backdrop is, the less likely the Federal Reserve will be to raise interest rates on Thursday.

In fact Cramer thinks that the Fed meeting is the most important event of 2015 for two reasons. First, this momentous decision from the Fed will surprise investors either way. Second, the consequences of a rate hike are bad news for stocks, but the upside from no hike is not positive enough to outweigh that downside.

Meaning, negative economic news could keep the Fed on hold but it could also cause earnings estimates to get slashed. Yet, better economic news could cause the Fed to raise rates, which is even worse news for the averages.

"It's a lose-lose situation for most stocks, creating a treacherous market, something that's all too easily forgotten on bullish days like today," the "Mad Money" host explained.

Federal Reserve building, Washington.
Getty Images
Federal Reserve building, Washington.
"It's a lose-lose situation for most stocks, creating a treacherous market, something that's all too easily forgotten on bullish days like today" -Jim Cramer

So, with this treachery in mind, Cramer created his Fed cheat sheet to explain the impact that the Fed's decision could have on stocks.

Upside: The Fed on hold
If the Fed indicates that it will stay on hold until it has more clarity on global weakness, then Cramer thinks there could be a dramatic rally, simply because one is needed so badly. However, if the Fed decided against raising rates for the rest of the year, we would see a very different impact than if the Fed said it will wait-and-see what happens.

Downside: The Fed raises rates
If the Fed decides to increase rates, Cramer anticipates six possible negative implications for the stock market. He wants investors to be ready for these downsides, especially if the Fed leaves the door open for more increases in short order.

No. 1 Higher interest rates will weaken the two strongest parts of the U.S. economy—housing and auto sales.

No. 2 The dollar could reverse its recent weaker trend and sharply strengthen versus the euro. This will cause earnings estimates for U.S.-based international stocks to be cut immediately.

No. 3 A higher dollar could cause many struggling emerging markets to collapse. Cramer is worried that markets such as Brazil will not be able to survive a rate hike.

No. 4 The Shanghai Composite will speed up its crash, big time. Cramer expects the Chinese market to plummet another 33 percent if the Fed tightens, because the U.S. is too linked to the Chinese markets, even if it is not linked to its economy.

No. 5 We will be fighting the Fed. A hike will take a tailwind and turn it into a headwind, which will make owning stocks more difficult.

No. 6 The Fed-induced surprise factor. Cramer expects many hedge funds that have bet the wrong way with borrowed money will need to liquidate.

The only potential positive that Cramer could see about a rate hike could be the statement that accompanies the Fed's action. A "one and done" comment could limit the downside for shareholders, and a clear statement could reduce the uncertainty in the market.

"Still, I am not about to stamp a smiley face on any rate hike," Cramer said. (Tweet This)

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Regardless of what happens with the Fed, Cramer wants investors to be prepared. If the market tanks, then it is time to go back to the winning stocks that won't be impacted by higher rates in a stronger dollar.

But do not forget that this is a market of stocks, and markets are all about supply and demand. There is too much stock supply out there right now, and less money going into equities by the day.

"Most important, we have to face some really important facts going into this meeting. We've had a terrific multiyear run in stocks. They are not cheap. At the same time, economies worldwide are turning down just when the Fed wants to raise rates. That is an unholy combination," Cramer added.

Ultimately, Cramer thinks that the rewards could be positive if the Fed does nothing. But he warned to be prepared for the enormous downside risk that could occur if the Fed does the wrong thing and raises rates without commentary. That is why he wants everyone to be prepared, with his six-point cheat sheet for the Fed.

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