The Fed is not as behind the curve on inflation as investors think, and that sets the stock market up for more gains ahead, Fundstrat says

• The stock market could see further gains ahead as inflation cools down, according to Fundstrat.
• The research firm believes the Federal Reserve is less behind the inflation curve than investors think.
• "Increasingly looks like markets mistook 'bullwhip' effect on supply chain for secular inflation," Fundstrat's Tom Lee said.

There are growing signs that the Federal Reserve is less behind the inflation curve than investors think, and that could set the stock market up for more gains ahead, Fundstrat's Tom Lee said in a Monday note.

"Increasingly looks like markets mistook 'bullwhip' effect on supply chain (including food) for secular inflation," Lee said.

The "bullwhip" effect references the fact that supply chains are incredibly fragile and typically have long lead times, which means any small change in consumer demand for a single item could lead to big swings in factory orders.

Those big changes in factory orders can then drive short-term price movements in the end product if supply and demand are not matched, and the COVID-19 pandemic did this for supply chains across many industries.

But this effect is typically short-lived as orders catch up (or fall) with demand, and there are signs that the price swings are finally easing after inflation surged to 40-year highs last month.

Commodity prices for industrial metals and agricultural commodities have plunged in recent weeks, with copper entering a bear market last week.

Retailers are holding onto record inventories that will need to be sold at discount prices, and housing prices are starting to be lowered as inventory hits multiyear highs.

And the auto industry is starting to see supply chain logjams ease as global shipments of automotive microchips return to 95% of pre-China lockdowns, Fundstrat said, citing data from Goldman Sachs.

"These are not congruent with 'inflation out of control,'" Lee said.

And with the Fed having already aggressively raised interest rates this year, any slowdown in inflation could spark a dovish pivot by the Fed and a pause in rate hikes, which would be supportive of risk assets, he said.

"If 'upside risk' to inflation is diminishing, Fed is less behind = positive for risk assets if the 'bullwhip' effect is indeed underway, we could see many of the inflationary pressures ease in the second half of 2022," Lee said.

He believes that would translate into big stock market gains because as investors remain fixated on lagging inflation readings, they are also exhibiting signs of extreme risk-off positioning in their portfolios.

Open interest among asset managers is near a record low, and retail equity flows saw the biggest outflows since 2008 last week, Lee observed.

"If retail and institutional are sellers, but inflation is softer, and Fed has done aggressive tightening already, doesn't it sound like risks are skewed to the upside?" he asked.

Fundstrat has a year-end price target of 5,100 for the S&P 500, representing potential upside of about 31% from current levels. Lee told investors that the first half of 2022 would be "treacherous" while a strong recovery rally would unfold in the second half of the year.