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Rising inflation impacts the stock market and more. Here’s how.

Rising prices are scaring investors. Here’s how inflation works, how it affects investments like stocks and funds and how to protect your money.

Just the FAQs, USA TODAY

When mature trees topple in the forest, it can seem plenty dangerous and disruptive at the time. But falling giants also open a pathway for fresh air and sunlight to reach the ground, giving saplings a chance to reach to the sky.

Is a similar situation playing out now in the stock market?

Today’s giants of the forest are technology-focused behemoths including Apple, Microsoft, Alphabet, Amazon, Tesla, Facebook and Nvidia, which currently represent seven of the 10 most valuable U.S. corporations. They have led the market’s charge in recent years, generating huge profits while crowding out hundreds of smaller stocks from investor portfolios.

Collectively, the top 10 accounted for 30% of the value of all 500 companies in the Standard & Poor’s 500 index at the end of January — one of the highest concentrations ever, reported JPMorgan Asset Management.

It’s hard to imagine a world without more cellphones, software, computers, online retail, electric vehicles and the like, and nobody is predicting these hallmarks of innovation will recede anytime soon.

Yet the market’s leaders arguably are so overvalued that they might offer subdued potential ahead. Many big tech stocks have slipped in recent weeks, possibly signaling that investors are paying more attention to neglected areas such as smaller companies, value plays and international equities. Rising inflation, higher interest rates and less government stimulus might be catalysts for that to happen.

Extreme popularity tends to wane

Stocks and industries rotate in and out of favor over time. Just think back to 1980, following the Arab oil embargo, when energy companies like Exxon, Mobil, Texaco and Chevron dominated the most-valuable list. Energy stocks in 1980 accounted for more than 25% of the S&P 500’s value; today, they’re around 3%.

Then there was the Nifty 50 era of the late 1960s and early 1970s when a few dozen companies led the way and were deemed, by some investors, as worth holding forever. But some of those stocks, like Xerox, Avon and Polaroid, have basically vanished.

An even more stark lesson can be found in the original components of the Dow Jones Industrial Average, which was started in 1896. None of the initial companies is still included today, and most aren’t even in existence. General Electric was the last to drop out, in 2018.

The point here is that things change — products, businesses and the economy — and investors should periodically take a reality check to make sure they aren’t falling too deeply in love with the stocks or funds that flourished in the past.

Investors tend to extrapolate recent successes into the future, often paying overly high prices for stocks that have done well, noted William Smead, chief investment officer at Smead Capital Management in Phoenix. However, “you can’t pay too much for a mature growth company and expect to win” over the long haul, he warned.

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Too much of a good thing?

Until recently, it was hard to find much to quibble about tech giants. But more recently, cracks have appeared that could point to slower appreciation ahead.

The relative earnings of the market’s 10 biggest stocks have started to slip, even though those 10 giant corporations (which also include Berkshire Hathaway, Visa and Johnson & Johnson) still weigh in at 30% of the S&P 500’s value, according to JPMorgan. They’re also selling at an average price-earnings ratio of around 30, compared with 20 overall for stocks in the index.

In particular, large growth stocks have taken a wild ride, generating an 18% annual return on average over the past decade, noted JPMorgan. By contrast, large value stocks have delivered a more-subdued 12.3% annual return over the past decade. Results are even lower for small growth (11.7% annually) and small value (10.6%) companies. Growth stocks tend to exhibit higher profit potential, while value shares sell at lower price-earnings ratios and pay higher dividend yields.

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The Federal Reserve signaled Wednesday that it plans to begin raising its benchmark interest rate as soon as March, a key step in reversing its pandemic-era low-rate policies that have fueled hiring and growth but also escalated inflation. (Jan 26)

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How millennials might factor in

Supercharged stock-market returns tend to cool off eventually, and now might be one of those transition periods.

Smead thinks the recent inflation uptick could persist. He points out that the huge millennial generation — the roughly 89 million Americans born between 1981 and 2000 — now all are reaching ages when they will buy more cars, homes, appliances and other big-ticket items, just as the roughly 74 million baby boomers did in the 1960s and 1970s, another era of high inflation.

If so, Smead argues that now is a good time to favor overlooked companies and sectors that can benefit from inflation. He cites homebuilders, pharmaceutical firms, real estate investment companies or REITs that own shopping malls and, especially, energy stocks.

With oil and other energy stocks accounting for only around 3% of the S&P 500’s value, investors including mutual funds and other institutions are underexposed, he believes. Meanwhile, oil prices have surged since their lows in April 2020, despite the emergence of more electric vehicles and other green-energy choices.

“Oil prices have recovered (but) the stocks haven’t,” Smead said.

Other investment possibilities

Many other investors are looking with growing concern at high valuations focused in large tech stocks, but they don’t all share the same conclusions on what it might mean.

For example, in a a report published in December, the Vanguard Group said it expected much lower market gains ahead, arguing that U.S. stocks haven’t been this overvalued since the dot-com bubble of the early 2000s. The outlook calls for U.S. stocks to return somewhere between 2.3% and 4.3% annualized over the next decade, well below the 10.6% annualized returns over the past three decades.

Members of Vanguard’s investment team said they expect value stocks to fare better than growth (4.1% a year compared with 0.1%), but they don’t forecast a difference between small and large companies (3.2% annualized for both). They see international stocks appreciating more than domestic ones, with 6.2% annual projected gains over the next decade. The stock market pullback over the past five or six weeks has crimped valuations a bit but hasn’t significantly altered these projections.

Nobody knows for sure what the future holds, but the market tumult of early 2022 might mark one of those inflection points when certain industries, sectors and investment themes rotate in or out of favor.

Now might be a good time to assess what you own, including the top holdings of your mutual funds and exchange-traded funds, and rebalance accordingly.

Even the healthiest, tallest trees don’t grow to the sky forever.

Reach the reporter at russ.wiles@arizonarepublic.com.

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