The bull case for stocks is still alive, but it's on increasingly shaky ground, DataTrek says

• There is still a bull case that suggests further upside for the stock market, according to DataTrek.
• The upside case hinges on inflation and rates decelerating considerably over the next six months.
• "If the market thinks real rates may be peaking now then stocks should rally in anticipation of declines over the next 6 months," DataTrek said.

Despite this year's consistent decline in stock prices, with all three major indices falling into a bear market, there's still an upside case to be made for stocks.

That's according to DataTrek Research co-founder Nicholas Colas, who told clients in a Tuesday note that a combination of factors, including a peak in inflation and interest rates, could drive stocks higher heading into 2023.

"Cautious as we are about the near-term direction of US/global equities, it always pays to consider the other side of the trade," Colas said, adding that the market typically looks six months out when pricing securities.

The first factor investors need to see to gain confidence in higher stock prices is a true peak in inflation, as well as its influence on the Federal Reserve's monetary policy.

According to Colas, five-year expected annual inflation sits at 2.4% today, which implies a steep decline from the current 8% run rate. That's a good sign for the bulls, and some of that decline should be visible over the next six months.

Meanwhile, markets are pricing in a peak in the fed funds rate between March and May of 2023, which is right in the middle of the six-month time horizon referenced by Colas. The combination of a peak in inflation and a potential Fed pause would remove a big overhang for investors.

"TIPS and Fed Funds Futures prices do currently support the idea that in six months inflation will be dropping and Fed policy will be moving into neutral," he said, adding that a decline in real rates has historically proven to be a solid environment for stock prices.

The bull case for stocks would only get stronger if analysts' corporate earnings estimates stop moving lower and bottom out. According to Colas, analysts have been cutting their earnings estimates by about 1% per month since June.

"While predicated on the assumption that corporate earnings can hold in around current levels, there is a pathway to believing that in six months' time analysts' estimates will have troughed and out-year estimates will show a resumption in growth," he said. "Pull these points together and you have a reasonable upside case for US stocks."

But there is still plenty of risk, and any derailment of the above factors would reset the six-month clock and lead to more doldrums for the stock market.

"The fly in the ointment is, of course, that it assumes no further bad news on inflation/Fed policy, corporate earnings, and investor risk tolerance. Disappointments on any/all of those fronts will reset the 6-month market clock," Colas concluded.