VIX Fear Gauge, Inflation Will Plummet by 2023

• Fundstrat’s Tom Lee predicts that volatility will plunge in 2023 when inflation drops back to 2%.
• This would be great news in the stock market, since big drops of volatility are associated with strong gains for stocks.
• “If VIX falls 20% (expected after surging >25), equity gains are far higher averaging 20%,” Lee said.

Wall Street’s fear gauge fell after a volatile year, which will allow the stock market to make big gains in 2023.

That’s what it says Fundstrat’sTom Lee, who believes the VIX IndexAfter inflationary concerns from equity investors ease, the Federal Reserve will likely see inflation drop to 20% next year.

“Based on our forecasts we expect Core CPI will be 2% (3 month annualized) by Dec 2022,” he stated in a Wednesday Note.

This is important because Fed Chairman Jerome Powell stated he wants to see consistent improvement on inflation returning to its long-term target of 2%. That is exactly what the 3-month annualized inflation represents, according Lee.

He also mentioned the ongoing drop in gasoline prices as a major lever that influences inflation expectations among consumers. This is why he expects that the University of Michigan inflation expectation reading will show significant declines over the next few month.

If inflation does continue to dropLee believes that this would be great news in the stock market for two reasons.

“First, Fed framework will likely change to a ‘predictable Fed’ because inflation is currently operating at or near their long-term goal 2%. This would be a huge dovish pivot and could mean Fed pauses completely in 2023,” he explained. “This is true, even if labor markets are solid.”

“Second: We expect equity and bond volatility will 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. 

Lee says that volatility was only higher than 2022 between 2008, 2009 and 2020, 2002, 2002, 2001 and 2002. All those years saw crises in equity market, including the Great Financial Crisis in 2008 and 2009, the COVID-19 pandemic 2020, and then the burst of dot-com bubble during the early 2000’s.

“When VIX >25 in a year, the following year sees a huge drop: average decline is 20%.” If volatility falls, equity multiples may expand as investors have less macro risk to worry about such as inflation and the Fed.

Lee pointed out that prior years’ VIX dropped significantly, and equity gains average 20% if VIX falls to 20%.

“VIX 12 month average has fallen 19 times in 19 years compared to the previous year. Equities saw positive gains 18 times out of these 18. There is a clear positive relationship. But if VIX falls 20% (expected after surging >25), equity gains are far higher averaging 20%,” Lee said.

A 20% increase in the S&P 500Current levels would place the index just below 4,555, which is just below Lee’s. 2023 year-end price target of 4,750.