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

Fundstrat's Tom Lee said in a Monday note that there are growing signs that the Federal Reserve is not behind the curve as investors think.

Lee said that markets mistook the bullwhip effect for secular inflation.

If a small change in consumer demand for a single item leads to big swings in factory orders, this is referred to as thebullwhip effect.

Short-term price movements in the end product can be caused by big changes in factory orders if supply and demand aren't matched, as was the case with the COVID-19 Pandemic.

There are signs that the price swings are finally easing after they surged to 40-year highs last month.

The price of copper entered 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 multi year highs.

According to Fundstrat, the auto industry is starting to see supply chain logjams ease as global shipments of automotive microchips return to 98% of pre-China lockdowns.

Lee said that these are not congruent with inflation out of control.

He said that a dovish pivot by the Fed and a pause in rate hikes would support risk assets.

If inflationary pressures ease in the second half of 2022, the Fed could be less positive for risk assets.

He thinks that would translate into big stock market gains because investors are showing signs of extreme risk-off positioning in their portfolios.

Retail equity flows saw their biggest outflows since 2008 last week, as open interest among asset managers neared a record low.

He wondered if the risks were skewed to the upside if retail and institutional were selling.

Fundstrat has a year-end price target of 5,100 for the S&P 500, which has a potential upside of 31%. A strong recovery rally would unfold in the second half of the year, as Lee told investors.