The S&P 500 has only reached this high a valuation three times in its history.

“Magnificent Seven” stocks account for over a third of the S&P 500.

An equal-weight S&P 500 ETF can reduce this overconcentration risk.

10 stocks we like better than Invesco S&P 500 Equal Weight ETF ›

The S&P 500 is undoubtedly the stock market’s most important index because it tracks the performance of around 500 of America’s largest and most influential companies. After a disappointing 2022 when the index declined by over 19%, it has been on a strong bull run, up more than 78% since the start of 2023.

This recent run is great news for investors who’ve been along for the ride, but it has also had another cautionary effect: The S&P 500 is now trading at historically high levels. One key metric that shows this is the Shiller price-to-earnings (P/E) ratio, sometimes known as the CAPE ratio.

The Shiller P/E ratio examines the S&P 500’s inflation-adjusted earnings per share (EPS) over the previous 10 years, aiming to provide insight into the index’s valuation without being influenced by one-off booms or slumps that could be misleading. The current Shiller P/E ratio is above 40 – a mark only hit three times in over 150 years.

Image source: Getty Images.

Unfortunately, the past couple of times the S&P 500 has hit this mark, bad times eventually followed (the dot-com bubble crash and the 2022 slump mentioned above). Now, past events don’t guarantee future events, but it’s well worth pointing this out to encourage investors to begin preparing for a potential market correction.

The S&P 500 is weighted by market capitalization, meaning larger companies account for more of the index than smaller companies. This setup is largely responsible for the index’s surge in the past couple of years.

Megacap tech stocks (like those in the “Magnificent Seven”) have exploded in valuations due to the current AI boom. As they’ve grown in valuation, they’ve accounted for a larger portion of the S&P 500, making their performance more influential on the index’s overall performance. It has worked in the S&P 500’s favor, but now the index is a little too concentrated in a handful of stocks, in my opinion.

The Magnificent Seven stocks – Nvidia, Microsoft, Apple, Amazon, Alphabet, Meta, and Tesla – now account for around 34% of the S&P 500. Its top 10 holdings account for over 38%.

One way to invest in the S&P 500 while avoiding the overconcentration problem and the risks that come with it is to invest in an equal-weight S&P 500 ETF, such as the Invesco Equal Weight S&P 500 ETF (NYSEMKT: RSP).