Wall Street’s Inflation Mistake

As inflation in the U.S. rises out of control, Wall Street should be scared.

Even though the CPI has been over 8% for the past three months, Wall Street still gives buy ratings to 56.9% of S&P 500 stocks and sell ratings to only 5.4% of the index.

Even in good markets, it's rare to see this many bullish ratings. The average number of buy ratings for the S&P 500 over the past five years is 53.3%, but even this is a high number in the past. FactSet says that Wall Street is more bullish than it has been in the last 12 years.

Why does Wall Street like inflation all of a sudden? Why do analysts tell people to buy when their ability to buy things drops? Let's talk about the mistakes Wall Street has made and why investors shouldn't be fooled by them.

Warren Buffett recently said (Trades, Portfolio) that when Wall Streeters charge big fees to manage trillions of dollars, the managers make a lot of money, not the clients. Wall Street might be wrong on purpose to make more money.

Buying illusions of strength

Wall Street makes more money when the market is up, so it wouldn't surprise me if some analysts gave more bullish ratings to boost investor confidence and trade.

But there's more. Inflation has been less of a problem for consumers in the short term because of policies like easy money and fiscal stimulus over the past few years, as well as the fact that people saved more money because of the epidemic.

Many companies still show growth in their quarterly earnings from year to year, so the effects are still going on. It's easy to think sales are better when numbers go up, but a company isn't growing if profits don't grow faster than inflation.

Costs are going up because of restrictions on the supply chain, and salary increases are still less than price increases. This means that the margins of many companies are getting better, which Wall Street loves. Restrictions on the supply chain give businesses with large moats the power to set prices.

This market environment has given the impression of strength that is too easy to buy into, which makes inflation look like it's good for stocks.

Inflation

Investors fall into a trap when inflation is high. The longer inflation lasts, the more it will add up and reduce people's ability to spend. Eventually, this will make price gains less important.

In a Fortune article from 1977, inflation was also very high.

In 2022, we all pay 100% income tax on any return that isn't higher than inflation, which in May was 8.6%.

Stagflation?

Some economists say they don't worry about inflation because they think it will soon go down. By making it easier for companies to raise prices without lowering demand, fiscal stimulus and savings from the start of the pandemic have contributed to inflation. By this reasoning, inflation will end when the ability of consumers to spend drops.

There's also a chance that inflation will stay high while economic growth stops. The United States had stagflation in the 1970s. The risk of stagflation has gone up because of the war between Russia and Ukraine.

According to the latest Global Economic Prospects report from the World Bank, global economic growth will slow from 5.7% in 2021 to 2.9% in 2022.

The Congressional Budget Office thinks that real GDP will grow by 3.1% in 2022. Before, there was hope that the Federal Reserve could cut inflation so low that it was less than economic growth, but now that seems unlikely. Rising geopolitical tensions between Russia and NATO could make the world economy even more unstable and slow down growth.

Buffett didn't say anything good about the stock market until November 1, 1974, when the market was at its most negative point during a long recession with inflation at 12.3% and GDP down 0.5%. By then, the S&P 500 had dropped by 42%. "Now is the time to invest and get rich," Buffett once said.

Still no recession.

Wall Street is optimistic about inflation because stock market gains have always come after recessions in the past. Analysts may be trying to predict the future, but they have forgotten one important fact: we haven't had a recession yet.

So far this year, the S&P 500 has lost about 20% of its market value, but consumption has been holding up well against inflation. A big part of the market drop comes from growth companies with prices that will make your eyes pop in 2020 and 2021. This year, Netflix and Meta Platforms have both lost almost half of their market value, which has hurt the S&P 500.

Wall Street is wrong about inflation because they got the timing and logic wrong. People who want to find deals might want to wait for a recession before going all in.