Investor Bias: How Inflation Illusion Causes Stock Mispricing

Interest rates and inflation are highly correlated historically. Higher inflation typically means higher interest rates.

When interest rates rise sharply, like in 2022, inflation expectations tend to rise as well.

Investors often overweight the negative impact of higher interest rates on stock valuations and underweight the positive impact of higher inflation on nominal earnings growth.

This "inflation illusion" causes investors to systematically undervalue stocks when inflation is high.

When inflation and rates fall in the future, investors are likely to make the opposite mistake and overvalue stocks.