The Democrats' election outperformance suggests the economy is not as bad as many think - and that's just one reason stocks are headed for a big year end rally, Fundstrat says

• Democrats' surprise turnout in the midterm elections suggests the economy and inflation isn't as bad as some think.
• That sets the stock market up for a significant rally into the end of the year, according to Fundstrat's Tom Lee.
• "If inflation is 'as bad as 1980s' I would have thought midterms would have been an incumbent massacre," Lee said.

The surprise outperformance of Democrats during last week's midterm elections represents a signal for investors that suggests there is more upside for the stock market heading into year-end, according to Fundstrat's Tom Lee.

That's because if the economy and inflation was as bad as some have been saying, it should have been an easy win for Republicans. Instead, the Democrats won the Senate, and the House of Representatives is still up for grabs, though as Monday morning it looks likely to be won by Republicans by a slim margin.

All-in, the Democrats are poised to lose fewer than 10 seats in the House of Representatives, well below the average loss of about 30 seats lost in a midterm election during an incumbent president's first term. That's especially impressive when you consider President Biden's approval rating has been at historically low levels, hovering around 41%.

"While many politicos call this an indictment of Trump, we think the bigger message is the economy is simply not bad enough for voters to kick out the Democrats. Inflation arguably is not bad enough that voters are blaming incumbents. Think about that. If inflation is 'as bad as 1980s' I would have thought midterms would have been an incumbent massacre," Lee said.

Thursday's better-than-expected CPI print, combined with consistent monthly job gains this year and a 2.6% boost in third-quarter GDP growth back up the idea that the economy is not yet falling apart.

Democrats better-than-expected performance in the midterm elections isn't the only reason why Lee expects gains for the stock market into year-end. Here are five more reasons why the S&P 500 could hit 4,500 by year-end, according to Lee.

1. The soft October CPI report showed a favorable "break" in three key inflationary areas: shelter, medical care and used cars. "We expect this to be sufficient for [the] Fed to slow pace of [interest rate] hikes, and possibly December 2022 may be the last hike," Lee said.

2. "Bond volatility is collapsing... this collapse in volatility, in our view, would support S&P 500 surging to 4,400 - 4,500 before year-end," Lee said.

3. "US yields saw a massive decline ranking in the bottom 1% largest downside moves in the past 50-years... yield declines of this magnitude portend further declines in rates six months and 12 months forward. In other words, chances are rising the highs of for the 2-year and 10-year yield are in further support of P/E multiple expansion," Lee said.

4. The US dollar saw one of its largest ever declines last week, falling nearly 6%, making it the eighth largest ever decline since 1970. "Increasingly looks like the top is in for US dollar," Lee said. That's good news for multinational companies that have taken a profit hit due to a soaring US dollar.

5. "Crypto had one of the tsunami of financial collapses ever, with liquidations of more than 300,000 accounts with leverage and the stranding of $10 billion or more in assets in FTX along with further contagion effects... Yet, the S&P 500 managed to post strong gains in the final two days of last week. This shows that investors are becoming more discerning, rather than 'hit the sell button' on any bad news," Lee said.