Analyst who called the rally says stocks can still go higher

The S&P 500's rally in 2023 surprised many. Last year, inflation was high, and most were concerned that ongoing Federal Reserve rate hikes would spiral the U.S. economy into recession.

Instead, stocks have rallied significantly because inflation has retreated, allowing the central bank to slow and potentially be done with raising rates, reducing recessionary worry.

The bullish backdrop caught many investors off guard, but Fundstrat's Tom Lee wasn't one of them. Last December, Lee told investors to expect a rally in 2023, and he doubled down on his bullish outlook this spring and again this summer.

So far, Lee has been right to be bullish. But he's not resting on his laurels. He still thinks stocks can head higher for this important reason.

The Fed may be done raising rates

In 2021, the Fed incorrectly stuck to the mantra "inflation is transitory" in explaining why it wasn't raising rates. That changed last year when the Fed was forced to shift hawkish when persistent supply chain disruptions and Russia's invasion of Ukraine caused prices to spike.

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The central bank's response was fast and relentless. Interest rates came into last year effectively at 0%, but they've increased by 5.25% since March 2022. The significantly higher cost of capital has caused borrowing costs to surge and banks to pull in their horns, tightening lending standards and shrinking loan amounts.

In response, the Consumer Price Index, the most closely watched inflation measure, has fallen to 3.2% in July, down from a peak above 9% in June 2022. This decline has Lee optimistic that the Fed will unlikely raise rates further following its recent increase in July.

"Fed Chair Powell's speech at Jackson Hole, in my view, was actually very constructive and supportive of our view that the Fed and FOMC remain data dependent," wrote Lee in a post on Real Money Pro. "We expect incoming data in coming months to tilt heavily "disinflation" and "softer jobs market," and the upshot is the Fed is not likely to raise rates again for this cycle."

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Not everybody agrees with Lee. The odds of a further increase to the Fed Funds Rate in September or November have increased in the past week. The CME's FedWatch tool currently puts the odds that rates rise 0.25% in September at 21%, up from 14% one week ago, and the chances for an increase in November increased to 48% from 38% last week.

Lee thinks the uptick in rate hike expectations will be temporary.

"There are many key reports next week. But the two that will sway the Fed most, arguably, are the July PCE deflator (inflation) and August NFP jobs report," wrote Lee. "We think payrolls will be soft, and we will have a fuller view on this later this week. JOLTS matters, and we expect this to lean soft. This means we anticipate odds of a September and November hike to fall this week from the current 21% and 42%, respectively. In fact, we expect both to eventually move towards zero."

If Lee is correct, 10-year Treasury yields should fall, and because those yields are used as the risk-free rate in stock valuation models, stocks could head higher.

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