The stock market's fear gauge will plummet in 2023 as inflation drops, setting the S&P 500 up for gains of 20%, Fundstrat says

• Volatility is set to plunge in 2023 as inflation falls back to 2%, according to Fundstrat's Tom Lee.
• That would be great news for the stock market, as big drops in volatility are associated with robust gains for stocks.
• "If VIX falls 20% (expected after surging >25), equity gains are far higher averaging 20%," Lee said.

After a heightened year of volatility, Wall Street's fear gauge is set to fall considerably in 2023, and that sets the stock market up for big gains ahead.

That's according to Fundstrat's Tom Lee, who expects the VIX Index to fall 20% next year after inflationary concerns among equity investors finally ease, and that would spark a big pivot from the Federal Reserve.

"Based on our forecasts, we expect Core CPI to be ~2% (3-month annualized) by December 2022," he said in a Wednesday note.

That's important because Fed Chairman Jerome Powell has said he wants to see consistent progress on inflation coming down back to its long-term 2% target, which is exactly what the 3-month annualized inflation represents, according to Lee.

He also pointed to the ongoing decline in gasoline prices as a big lever that helps shape inflation expectations among consumers, which is why he expects the University of Michigan inflation expectation reading to show sizable declines over the next few months.

If inflation does continue to drop, as Lee expects, that would be great news for the stock market for two big reasons.

"First, Fed framework likely changes to 'predictable Fed' as inflation is now operating near their long-term goal of 2%. This would be a massive dovish pivot, and could mean Fed pauses entirely in 2023," he explained. "This is true even if labor markets remain solid."

"Second, we expect equity and bond volatility to fall 20% or more. The VIX averaged >25 in 2022, and since inception, the VIX falls a median 19.5% in the following year," Lee added.

Volatility has only been higher than 2022 in 2008, 2009, 2020, 2002, and 2001, according to Lee. All of those years represented crises in equity markets, with the Great Financial Crisis of 2008 and 2009, the COVID-19 pandemic of 2020, and the popping of the dot-com bubble in the early 2000's.

"When VIX >25 in a year, the following year sees a huge drop: average decline is 20%." And if volatility drops, equity multiples can expand because investors will likely have less macro risks to worry about, such as the Fed, inflation, and interest rates.

"If VIX falls 20%, equity gains average 20%, suggesting stocks could do very well in 2023," Lee said, pointing to a data analysis of prior years the VIX fell considerably.

"There are 19 years when VIX 12 month average fell versus prior year. Of these 18 times, equities posted positive gains. There is an obvious positive relationship. But if VIX falls 20% (expected after surging >25), equity gains are far higher averaging 20%," Lee said.

A 20% surge in the S&P 500 from current levels would put the index just below 4,585, which is just below Lee's 2023 year-end price target of 4,750.