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The odds of a more than 20% gain are on the rise as the Fed turns dovish amid transitory inflation, Fundstrat says

Thomas Lee Tom Lee FundstratTom Lee was formerly JPMorgan’s chief equity strategist.

Brendan McDermid/Reuters

  • Odds are rising that the stock market will gain more than 20% in 2023, according to Fundstrat.
  • That’s because inflation is proving transitory, and that will lead the Fed to turn more dovish.
  • “The bond market argues the Fed needs to end the war soon,” Fundstrat’s Tom Lee said.

Odds are rising that the US stock market will deliver a more than 20% gain in 2023 as inflation falls and the Federal Reserve makes its long-awaited pivot toward a more dovish monetary policy, according to a Wednesday note from Fundstrat’s Tom Lee.

The key to Lee’s bullish thesis on stocks is that inflation continues to fall swiftly, and that the Fed recognizes the decline and will adapt to it.

Data released on Wednesday showed a larger than expected decline in December’s producer price index, which dropped the most since the start of the pandemic. The PPI fell 0.5% last month, compared to estimates of a 0.1% gain.

On a three-month annualized basis, PPI is running at just over 1%, which will help drive inflation back down to the Fed’s long-term 2% target. And the recent data argues that the Fed is too hawkish as inflationary data is showing clear signs of easing. 

“The bond market argues the Fed needs to end the war soon,” Lee said, highlighting the drop in bond market volatility.

For stocks to see big gains this year, two things need to happen, according to Lee.

“First, inflation data needs to continue to track at this ‘leg down’ level and we expect <3% annualized inflation for next six months. Second, the Fed needs to own up to this ‘leg down’ (which bond market sees). This is not true if Fed is willing to push economy off a cliff needlessly,” Lee said. 

The Fed has already turned less hawkish than it was for most of last year, with its most recent rate hike being 50 basis points rather than the outsized 75 basis points it got comfortable with during 2022. The Fed is expected to hike interest rates by just 25 basis points at its February FOMC meeting, and a pause in rate hikes could come soon after that. 

While a 20% gain would be no small feat for the stock market, it has several different tailwinds that suggest odds of success are rising, according to the note.

“53% of all post-negative years are up more than 20%, meaning high odds of >20% rise for S&P 500 in 2023,” Lee said. That probability of a more than 20% gain this year rises to 90% if the S&P 500 is up more than 1.5% in the first five days of the year, or if the VIX averages below 25 in 2023, Lee noted.

The S&P 500 was up 0.8% in the first five trading days of the year, but finished up 4% in the first 10 days of the year. Meanwhile, the VIX dropped below 20 last week, and the index started the year off at about 23. 

“Pick your poison, but both of above conditions seem to be coming together,” Lee said. 

Read the original article on Business Insider