Record highs for the stock market are within reach this year as shaky earnings results show bad news is already priced in, Fundstrat says

• The stock market could hit record highs by year-end as disappointing earnings fail to spark a big sell-off, according to Fundstrat.
• Investors prepared themselves for a barrage of bad news, and that's great for the stock market.
• "Investors are punishing [earnings] misses to a far less extent," Fundstrat's Tom Lee said.

The stock market could hit record highs by the end of the year as investors have already priced in a lot of bad news, Fundstrat's Tom Lee said in a Friday note.

That's evidenced by the fact that disappointing earnings results have failed to spark a significant sell-off in the stock market so far, with the S&P 500 still up about 6% year-to-date. And that might come as a surprise to investors and strategists who currently have a bearish tilt.

"There are those who say earnings are the next 'shoe to drop' but EPS estimates [have] been falling for many months already. So, what arguably matters more is how are stocks reacting to EPS results," Lee said.

On that front, investors aren't punishing companies that miss earnings estimates today as much as they were several months ago.

According to Fundstrat, companies that have missed fourth-quarter earnings results so far have dropped by an average of about 1%. That's much better than the average 2.5% to 3% sell-off seen for companies that missed earnings estimates from the third quarter of 2021 through the third quarter of 2022.

What's more is that the two sectors that have posted the best year-to-date returns so far are the same sectors that have experienced the biggest negative earnings revisions in the fourth quarter: communication services and consumer discretionary.

"Investors are punishing misses to a far less extent," Lee explained. "Again, highlighting a lot of the bad news of 2023 EPS is getting priced in. This doesn't mean EPS falling is good, but this does show lots are priced in."

Improving reactions to earnings give Lee confidence that several bullish signals that hit the stock market in January will help drive the S&P 500 up another 18% this year to 4,800, which is around the level where stocks topped out in January 2022.

Also working in favor for more potential upside in stocks this year is the fact that most investors are still bearish and have yet to flip to a bullish stance that would drive gains. That's been evidenced in persistent negative investor sentiment and the average Wall Street year-end price target of 4,050, which represents a 1% decline from current levels.

"It will be an 'exception' if equity markets weaken... For the most part, the equity gains YTD have been met with skepticism and warnings of 'bear market trap' by most pundits and strategists... But as the above analysis shows, market internals are speaking a far different story. If the equity markets defy one's framework, it might be time to revisit the narrative," Lee said.