More than half of CPI components are in deflation mode, and that's great news for the stock market, Fundstrat says

• The December CPI report showed 59% of its components "are now in deflation," Fundstrat's Tom Lee said in a Friday note.
• That's good news for the stock market, as a drop in inflation will help ease financial conditions.
• "This is setting up 2023 to be the opposite of 2022, where inflation expectations fall faster than EPS risk," Lee said.

The release of December's CPI print this week provided investors some relief as inflation met expectations, rising 6.5% year-over-year and falling 0.1% on a month-over-month basis.

The big takeaway from that report, according to Fundstrat's Tom Lee, is that 59% of CPI components are now in deflation mode.

"The December CPI report is a net positive, as we think investors will increasingly come to the conclusion the Fed can declare 'mission accomplished' on inflation," Lee said in a Friday note.

That's great news for the stock market, as a continued drop in inflation will help ease financial conditions and spark a drop in Wall Street's volatility index, which typically has an inverse correlation to stock prices.

If such a scenario plays out, it would be the exact opposite scenario seen in 2022, in which "inflation expectations fall faster than EPS risk," Lee said.

Lee expects falling inflation to be a lasting trend in 2023 because "the pace of items 'deflating' is also well above the long-term average," according to the note. Some of the items that saw big price drops in December's CPI report included various energy commodities, used cars and trucks, and airline fares.

"For an equity investor, what is evident is inflation is falling faster than expected. And the Fed's motivation to push for a 'hardish' landing is diminishing given the softening of the labor market," Lee said.

What's should be top of mind for the Fed as it determines its monetary policies going forward is wage growth, which has visibly slowed in recent weeks.

"Recall last week, total income (payrolls * average hourly earnings) are now growing at a mere 3.6% or so, in line with levels needed to sustain 2% inflation," Lee said.

"These economic reports arguably show the bond market got it right. Inflation is undershooting the Fed and consensus view and thus, explain the fact that 2-year and 10-year Treasury yields are far below the 5% Fed terminal rate," Lee said.

With the Fed having less pressure to re-accelerate its interest rate hikes, volatility is likely to fall, and that's great news for stocks. Whereas the VIX averaged 25 in 2022, Lee expects the volatility index to fall below 20 for most of 2023. The VIX fell 3% to 18.33 on Friday.

"Our past analysis shows that in the past, this implies stocks could gain more than 20% in 2023. And with the strength in the first 5 days [of 2023], this case seems stronger," Lee said.