Here are the kinds of stocks set to rally as the stock market changes its character amid inflation 'falling like a rock', according to Fundstrat's Tom Lee

Tom Lee
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  • The character of the stock market is changing as inflation starts to fall "like a rock," according to Fundstrat's Tom Lee.

  • A drop in inflation would offer the market numerous rallies to keep momentum into year-ed, Lee said.

  • These are the types of stocks that see short-term upside if inflation continues to fall, according to Lee.

Inflation is starting to drop "like a rock" and that's great news for the stock market, according to Fundstrat's Tom Lee, who expects a year-end rally to drive the S&P 500 to as high as 4,500 and for certain stocks to see a strong boost.

Lee's confidence behind declining inflation stems from recent moves in the bond market, with the 10-year US Treasury yield falling as much as 0.86% from 4.34% to 3.48%.

"The bond market has 'sniffed' out inflationary pressures are breaking to the downside," Lee said, adding that even the US Dollar has dropped 9% from its peak over the past two months.

"Taken at face value, consider how these impact stocks: Lower yields= higher p/e, lower US Dollar = upside to forward EPS as the +20% surge in [the] US Dollar subtracted ~8% from 2022 EPS growth," Lee said.

This puts the stock market at a key juncture as the S&P 500 tests resistance at its 200-day moving average, and its character is trending more positive even as most investors remain bearish, according to Lee.

The bearish sentiment among investors was evidenced by Morgan Stanley's Monday note recommending investors to fade the recent rally and sell stocks. Meanwhile, the most recent results from the weekly AAII Investor Sentiment Survey showed 40% of respondents are still bearish on stocks over the next six months, well above its 1-year average of 31%.

"We think the above illustrates the need for consensus to rethink the central narrative. The Fed and bond market are no longer acting as if inflation is as sticky as many expect," Lee said.

More evidence of falling inflation could be found in gasoline, with the entire 2022 surge in gas prices being erased in recent days. According to average national prices from AAA, prices are back down to $3.40 after surging to higher than $5 earlier this year.

"Higher gasoline has a major impact on how US consumers perceive inflation. Thus, the fall in gasoline will have an impact on both actual and perceived inflation," Lee said. Lee also highlighted that during the 1970's period of high inflation, gasoline prices never eased lower like they have so far this year.

"Bottom line, in our view, is the equity market has changed character. Stocks are proving to be far more resilient. And we believe the Fed has shifted to become far more predictable, away from the 'higher in a hurry," Lee said.

These are the types of stocks that should benefit most from falling inflation and a year-end market rally, according to Lee.

1. "Heavily shorted names."

AMC Entertainment, Cinemark, ARK Innovation ETF, Coinbase, Carnival Corporation, Wynn Resorts, and the KraneShares China Internet ETF.

2. "High P/E stocks which are down 90% to 98% get 'rented' to be down only 60% from highs."

 Zoom Video, CrowdStrike, and Shopify.

3. "Technology stocks, which have been hardest hit due to higher rates surge."

The Nasdaq 100 ETF, Amazon, Microsoft, Netflix, Alphabet, and semiconductor stocks.

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