A pause in the Fed's interest rate hikes would drive a massive allocation shift to stocks, Fundstrat's Tom Lee says

• Equity allocations could surge if the Federal Reserve pauses its interest rate hikes at the end of this year, according to Fundstrat.
• "A pause simply means [the] Fed is shifting back to data dependency," Fundstrat's Tom Lee said.
• Such a pause would come at a time when investors' net allocation to equities is at a level lower than in 2008.

The stock market could be gearing up for big upside as the Federal Reserve gets potentially closer to a pause in its interest rate hikes, according to a Wednesday note from Fundstrat's Tom Lee.

The Fed is expected to hike interest rates another 75 basis points at its November and December meetings but could stop after that, according to Lee.

"A pause simply means [the] Fed is shifting back to data dependency," he said, rather than playing catch-up in its bid to tame inflation via outsized rate hikes. A pause is different from a pivot, which was expected by some investors earlier this year, as a pivot would likely entail a reversal of the Fed's rate hikes in the form of interest rate cuts.

If the Fed does raise rates by 75 basis points at its last two meetings of the year, the fed funds rate would be between 4.50% and 4.75%. According to Lee, that level should be "sufficiently restrictive for the Fed to be allowed to take a look around" and see how its rate hikes flow into the economy.

A Fed pause could come at a time when investors' net allocation to stocks is at a lower level than in 2008, and a pause would likely spark a "significant asset allocation change" in investor portfolios, according to Lee.

"Investors are not positioned for a pause. Fixed income investors have been betting on higher rates. Retail equity investors are buying record levels of puts surpassing that of COVID-19 lows. Institutional investors, per BofA, are 3 standard deviations underweight equities, [and] even corporate insiders are beginning to buy stocks again," he said.

"Would the Street still keep these positions if there was a pause? We don't think so," he added.

And the Fed will likely have good reason to pause in the coming months, as "soft" data shows cooling inflation while "hard" data continues to lag. Half of the consumer price index's goods and commodities inflation has fallen from its peak, while home prices show signs of cooling off, according to Lee.

Amid the shift in goods and commodities pricing, some economists expect headline CPI inflation to cool to 6.8% despite September's higher-than-expected 8.2% reading. "Falling 1.2 percentage points in two months is a major decline," he said.

Lee remains optimistic on what the stock market can do in the next few months. The strategist has a 5,100 year-end price target for the S&P 500, which represents potential upside of 38% from current levels.