Falling inflation, record cash on the sidelines, and palpable fear are creating a bullish set up for stocks

• There is a bullish setup brewing for the stock market despite fears of a banking crisis, according to Fundstrat's Tom Lee.
• Broken inflation, record cash on the sidelines, and heightened investor fear represent bullish catalyst for stocks.
• "I think inflation is finally dead in a lot of ways, and that's constructive for what happens to [stock] multiples," Lee said in a webinar on Thursday.

There's a bullish setup forming in the stock market despite growing fears of a banking crisis after the collapse of Silicon Valley Bank and uncertainty surrounding Credit Suisse, according to Fundstrat's Tom Lee.

In a webinar with clients on Thursday, Lee highlighted three key factors that could serve as fuel for the stock market to climb higher throughout the rest of the year, potentially driving 22% upside to his year-end S&P 500 price target of 4,750.

Those factors include "broken" inflation, a record amount of cash on the sidelines, and a surge in bearish sentiment among most investors.

'Inflation is finally dead'

The main culprit of what drove the stock market to experience its worst annual performance since the Great Financial Crisis last year was inflation, as the Federal Reserve aggressively hiked interest rates to combat rising prices, which led to a broad risk-off environment for all types of asset classes.

But that's finally reversing, according to Lee, who noted that recent data shows that inflation is continuing to soften.

"Inflation is not accelerating in February, it's actually softening. Especially outside of housing," Lee said.

"I think inflation is finally dead in a lot of ways, and that's constructive for what happens to [stock valuation] multiples."

The uninversion of the yield curve could be indicative of a broken inflation narrative, according to Lee, as it would give the Fed more flexibility in slowing down or pausing its interest rate hiking trajectory.

Investors remain overly bearish

Investors can't shake their bearish feelings as crisis after crisis unfolds, leading to volatility surges in both equity and bond markets. But such excessive bearishness could ultimately serve as dry powder that could fuel stocks higher as it fades.

"I think that in the 30 years I've been covering markets the one observation I'd make is that the market seems more prone to panic today than it has in the past. I think it's been amplified by the pandemic, but the SVB collapse has triggered another wave of panic," Lee explained.

"Retail investors [have] never been this bearish. Their sentiment remains stalwartly negative. It hasn't improved at all since January" when it hit a record low, he added, pointing to a rolling 52-week average of the AAII investor sentiment Bull-Bear spread.

According to the most recent survey, bearish sentiment soared over the past week with nearly half of respondents displaying a bearish view towards stocks.

Record cash on sidelines

What goes hand in hand with bearish investor sentiment is a surge in cash on the sidelines, which is currently sitting at a record $1.8 trillion among retail investors.

"There's more money on the sidelines than there was in May 2020. It's the panic out there that's triggering people to be on the sidelines. And I think it's that panic that when it subsides is money that moves back into [stocks]," Lee said.

As long as the US banking crisis is contained and inflation continues to show signs of easing, he is staying bullish on stocks.