The October CPI report was a 'game changer' for the stock market and could lead to a 25% rally over the next 50 days, Fundstrat says

Thomas Lee Tom Lee Fundstrat
Tom Lee was formerly JPMorgan's chief equity strategist.Brendan McDermid/Reuters
  • The stock market could soar 25% over the next 50 days after the October's "game changer" CPI report, according to Fundstrat.

  • The CPI report showed lower than expected inflation, leading to a more than 5% surge in the S&P 500 on Thursday.

  • "Valuation nor earnings constrain stocks if inflation has bottomed," Fundstrat's Tom Lee said.

The stock market has considerable upside potential into year-end after October's "game changer" CPI report, Fundstrat's Tom Lee said in a Friday note.

Specifically, Lee believes the S&P 500 could surge as much as 25% over the next 50 days because the Federal Reserve no longer has its back to the wall as inflation shows signs of easing and stock valuations remain supportive.

Lee highlighted three drivers behind the soft October CPI report, which he believes are "repeatable" for next month's CPI release. Those include shelter prices showing a meaningful slowing in month-over-month CPI, from a high of 0.8% in September to 0.6% in October.

That suggests housing data is "trending towards market reality of deflation," Lee said.

Medical health insurance and durable goods also saw significant declines, driven in part by tough year-over-year comparables and a steady decline in used car prices.

"There are building drivers to massively slow CPI core inflation over the few months and it is possible we will see three to four consecutive months of +0.3% Core CPI month-over-month," Lee said. That would pull down core inflation to 3.5%, nearly half of the 6.5% reading seen in most of 2022.

The slowing inflation readings have a big impact on what Fed Chairman Jerome Powell is going to do next, and Lee believes a pause in rate hikes is imminent, which would counter the recent hawkish rhetoric from Fed members.

"For most of 2022, Fed has not been able to point to measurable progress on containing inflation but a significant constellation of leading indicators showed deflation/soft inflation was in the pipeline. October CPI is the first month the 'hard' data syncs with the 'soft' data," Lee explained.

On top of October's CPI report increasing the likelihood of a Fed pause, or at least slowdown in its aggressive interest rate hikes, it also increases the chance of a soft economic landing, which runs counter to market consensus that the Fed is about to break the economy.

All of this would be supportive of risk assets, specifically stocks, and valuations support further upside ahead.

According to Lee, since 1871, the average price-to-earnings ratio when the 10-year yield was 3.5%-5.5% is 19x. The forward and trailing P/E ratio for the S&P 500 is 16.1x and 17.8x, respectively, as of November 4. That suggests further room to run.

"Valuation nor earnings constrain stocks, if inflation has bottomed," Lee said.

Lee's call for a 25% rally would send the S&P 500 to new record highs at just below 5,000, and history suggests that's not out of the question.

"Recall, in 1982, following the final low in August 1982, the S&P 500 reached a new all-time high within 4 months, erasing entire 27-month bear market. That was a vertical rally. Vertical," Lee reminded investors.

While the Fed likely hasn't vanquished inflation yet, the stock market is forward looking and has previously "sniffed" out the end of inflation months before it happened in 1982, Lee concluded.

1982 stock market chart
Fundstrat

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