Warren Buffett on Why Wall Street Is Wrong About Inflation

With inflation soaring in the US, historical precedent would tell us that Wall Street should be panicking right now.
However, it does exactly the opposite; Even though the CPI has been over 8% over the past three months, Wall Street maintains buy ratings on 56.9% of stocks in the S&P 500, compared to sell ratings on just 5.4% of the index.
This many bullish ratings would be considered highly unusual even in good market conditions. The five-year average buy rating for S&P 500 stocks is slightly lower at 53.3%, but even that is unusually high on a historical basis. FactSet has been collecting data on Wall Street ratings since 2010, and according to the record, Wall Street is now the most bullish it has been in at least 12 years.
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So what made Wall Street suddenly like inflation? Why are analysts issuing buy recommendations left and right when consumers' purchasing power is rapidly dwindling? Let's take a look at where Wall Street is going wrong and why investors shouldn't be fooled.
Before we get into that, though, let's remember that, as Warren Buffett (Trades, Portfolio) once said, when trillions of dollars are being managed by Wall Streeters who charge high fees, it will usually be the managers who charge outsized Bring in the profits, not the customers. In other words, if Wall Street is wrong, it could very well be an intent designed to boost Wall Street profits.
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Indulging in an illusion of strength
The more bullish the market, the better Wall Street's gains, so I wouldn't be surprised if some analysts deliberately issued more bullish ratings to bolster investor sentiment and encourage active trading.
However, this is not the only factor at play here. Thanks to record-breaking monetary policy and fiscal stimulus in recent years, and higher savings since the pandemic began, consumers have gained an unusual level of short-term resilience to inflation.
That won't last forever, but for now, the impact is lingering in the minds of analysts and investors alike, as many companies are still reporting quarterly earnings that are improving year-over-year. It's easy to be fooled into thinking that sales will improve when numbers rise, when technically a company isn't actually growing unless earnings are growing faster than inflation.
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Additionally, as supply chain constraints push prices higher and wage increases continue to be lower than quoted price increases, many companies are seeing their margins improve, which Wall Street loves. Supply chain constraints give certain companies tremendous pricing power, especially those with strong competitive advantages.
This market situation has created an illusion of strength that is all too easy to buy into, making it almost seem like inflation is actually good for the stock market.
Buffett on inflation
Seeing high inflation as a good thing is a dangerous trap for investors. The longer inflation lasts, the more it will intensify, eroding consumers' purchasing power, creating downward pressures that will eventually outweigh price increases.
In a Fortune magazine article published in 1977, at another time when inflation was running hot, Buffett provided the following anecdote:

The arithmetic makes it clear that inflation is a far more devastating tax than anything our legislators have enacted. The inflation tax has a fantastic ability to easily consume capital. For a widow with her savings on a 5% savings account, it makes no difference whether she pays 100% income tax on her interest income in times of zero inflation or pays no income tax in years of 5% inflation. In either case, she is "taxed" in a way that leaves her with no real income. Any money it spends comes directly from capital. She would find a 100% income tax outrageous but doesn't seem to realize that 5% inflation is the economic equivalent.

To bring this example forward to 2022, we all pay essentially 100% income tax on any return that doesn't exceed inflation, which was 8.6% in May.
Is stagflation imminent?
Some analysts claim they are not worried about inflation because they expect it to ease soon. Their reasoning is that since the pandemic began, the fiscal stimulus and austerity measures have contributed to inflation by making it easier for companies to raise prices without a significant drop in demand. Naturally, by that logic, once consumer purchasing power falls off a cliff, inflation will disappear.
On the other hand, even if economic growth stagnates, we could end up in a situation where inflation persists. This situation, known as stagflation, last occurred in the United States in the 1970s. The likelihood of stagflation has increased further as a result of Russia's war against Ukraine.
According to the World Bank's latest Global Economic Prospects report, global economic growth is expected to slow to 2.9% in 2022 from 5.7% in 2021, a significant drop from the 4.1% growth forecast for 2022 released in January means.
As of May, the Congressional Budget Office estimates that U.S. real gross domestic product will grow 3.1% in 2022. Previously, there was some hope that the Federal Reserve could help bring inflation down enough for the year to lag behind economic growth, but that seems unlikely at this point. Additionally, should there be further disruption to the global economy from rising geopolitical tensions between Russia and NATO, we could see a further slowdown in economic growth.
The last time the US experienced stagflation, Buffett waited until November 1, 1974 -- the peak of market pessimism amid a long recession with inflation rising to 12.3% and GDP falling 0.5% to announce a bull market in the stock market. At that point, the S&P 500 was down more than 42%. In one of the most direct predictions of his entire career to date, Buffett declared, "Now is the time to invest and get rich."
We haven't seen a recession yet
The history of steep recessions followed by long-term gains may be one reason Wall Street is so bullish on inflation. Maybe analysts are trying to think ahead, but in doing so they've forgotten a key factor: We haven't had a recession yet.
Sure, the S&P 500 has lost about a fifth of its market value year-to-date, but consumer spending has held up well against inflation so far, and much of the market's decline has come from growth stocks, which have bid high at stunning valuations in 2020 and 2021 Netflix (NASDAQ:NFLX) and Meta Platforms (NASDAQ:META) are among the S&P 500 juggernauts that have lost over 50% of their market value this year, which has helped drag the top-heavy index lower.
Wall Street is wrong about inflation because they got the timing and the reasoning wrong; Like Buffett in the 1970s, those looking for bargains might want to wait until an actual recession develops before going all out.
This article first appeared on GuruFocus.
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