Investor sentiment is so bearish that it's pointing to a potentially huge rally in the stock market as inflation keeps falling, Fundstrat says

• Investors are so bearish on stocks that it could signal big gains ahead, Fundstrat's Tom Lee said.
• Lee forecasted the S&P 500 to rise 14% over the next 12 months as falling inflation boosts equities.

Investors are so bearish on stocks that the market could see a potentially huge rally as the inflation situation improves, according to Fundstrat's head of research Tom Lee.

In a note on Monday, Lee pointed to strong bearish sentiment in the stock market, with 41% of investors saying they felt pessimistic on their outlook for stocks over the next six months, according to the latest AAII survey. Lee added that the majority of Fundstrat's institutional investor clients believed the S&P 500 would soon plunge by about 15% to retest its low in October of last year.

But that's contrary to bullish indicators that are flashing in the market, Lee said, largely due to inflation falling. He forecasted that the benchmark index would actually rise 14% to 4,750 over the next 12 months.

"Investor position is so negative, hard to cause further downside," he said, adding that less sticky inflation would resolve many of the issues that are turning investors so bearish.

Inflation has been on a slow but steady decline for nearly all of the past year, cooling to 4.9% in April's Consumer Price Index report. Though some economists have warned inflation could remain stubborn at 3-4%, Lee has made the case that prices could be set to see a steep drop due to falling indicators like housing costs.

Falling inflation is likely to give the Federal Reserve reason to dial back its tightening of monetary policy which could be bullish for equities.

Though investors are still skittish over recent banking turmoil, the debt ceiling crisis, and a potential corporate earnings recession, falling inflation should resolve many issues markets are fretting about, Lee said.

Other Wall Street strategists are still sounding that alarms for this year, with Bank of America warning that the economy could tip into recession as soon as this quarter. Lee, for his part, has been bullish on stocks for most of the past year's bear market, and previously predicted the S&P 500 to hit a new record last year, though the index ultimately notched its worst performance since 2008.