One of Wall Street's Most Bullish Market Strategists Sees a 3-Phased Market Coming That Includes a Correction or Bear Market

Tom Lee of Fundstrat is undeniably one of Wall Street's most bullish market strategists.

In fact, it's unusual for Lee not to be bullish. To his credit, Lee has nailed most of his bull market calls over the past several years. Interestingly, however, Lee recently appeared on CNBC to discuss what he called an upcoming three-phased market. Lee expects a bumpy ride in the near term, including a correction or bear market that could begin shortly. Let's take a look.

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The market is about to run into a host of challenges

At recent prices, the benchmark S&P 500 (SNPINDEX: ^GSPC) index has risen nearly 11% this year. That's impressive, considering all the challenges it's had to overcome, including doubts about artificial intelligence (AI) at the beginning of the year and then the Iran war, which has led to higher oil and gas prices that are likely contributing to elevated inflation.

However, Lee said the market has been bolstered by incredibly strong first-quarter earnings. According to Lee, most market forecasters had penciled in $70 of collective earnings per share (EPS) for the S&P 500. First-quarter EPS actually came in at about $80, a big beat on expectations for what had already been expected to be a strong quarter of growth.

If the market stays on this trajectory, that's $40 in additional EPS on an annualized basis, which could lift the S&P 500 by 800 to 1,000 points, according to Lee. However, Lee's base case, based on what he and the team at Fundstrat had expected to be a "challenging year," is a three-phased market.

The first phase, currently underway, is largely bullish. With the S&P 500 now slightly above 7,560 (as of June 3), Lee thinks the rally could last a little bit longer, potentially taking the market to around 7,700.

The second phase, which will shortly follow, will be a challenging period for the market.

"Then we are going to digest a lot of things until October," Lee told CNBC. "And that's a new Fed chair; it's the energy shock ... especially shortages of petroleum products and lubricants. ... And the third is the IPOs of SpaceX, OpenAI, and Anthropic that when the unlocks happen, that's a lot of extra supply.

By "unlocks," Lee refers to the expiration of lock-up provisions that allow insiders and employees with company shares to sell those shares in the public market.

"I think that could pressure stocks in a way that feels like a bear market," Lee added.

However, Lee sees this more difficult period settling after the midterm elections, at which point he expects stocks to rally strongly, with 2027 yielding "some of the best we've ever seen in our lifetime."

How investors should approach a three-phased market

Lee is not the only one who thinks the market is approaching levels that could trigger a correction or a bear market. The biggest risks right now appear to be the Iran war dragging on and inflation remaining elevated.

If bond yields keep rising, I don't think the market would respond well. I could also see the Fed having to step in with a rate hike.

It's also possible that these massive trillion-dollar initial public offerings siphon liquidity and demand from other large tech and AI stocks. If they don't see good demand, investors could also get concerned that demand for AI is starting to hit a wall.

Of course, if Lee is right and things do settle down following midterms, then investors don't need to do anything to their portfolios. However, I don't think long-term investors should focus on near-term calls, which are extraordinarily difficult for anyone to make.

But the fact that Lee, who is almost always bullish, sees a pullback coming shows that the market has reached high levels that feel unsustainable.

If you are a long-term investor with a five- or 10-year horizon, there is no need to do much, other than stay aware of the situation. However, if you are focused on preserving current levels of capital, then it is likely time to take some gains off the table, raise cash, or add some more protective stocks or exposure to sectors that are more resilient in sell-offs.

The first step is to identify your goals and timeline. Then review your portfolio and create a plan so you are prepared for a near-term pullback if it materializes.

Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.