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Mega-cap growth stocks continue to dominate the broader market and contribute the bulk of gains in the major indexes like the S&P 500 and Nasdaq Composite. But the sheer value of some of the largest companies might surprise you.

The “Magnificent Seven” is a term coined by Bank of America analyst Michael Hartnett to describe seven industry-leading tech-focused companies: Microsoft (NASDAQ: MSFT), Apple (NASDAQ: AAPL), Nvidia (NASDAQ: NVDA), Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG), Amazon (NASDAQ: AMZN), Meta Platforms (NASDAQ: META), and Tesla (NASDAQ: TSLA).

These seven companies are now so valuable that they make up a combined 35.5% of the S&P 500. Here’s what these changing market dynamics mean for the stock market and how to position your portfolio in a way that matches your risk tolerance and helps you achieve your investment objectives.

Image source: Getty Images.

A double-edged sword

The S&P 500 is up over 44% since the end of 2022. The primary reason is that the sectors containing Magnificent Seven stocks are outperforming the S&P 500 as a whole, while the other eight sectors are underperforming.

^IXT data by YCharts.

Microsoft, Apple, and Nvidia are in the tech sector. Alphabet and Meta Platforms lead the communications sector. And Amazon and Tesla are in the consumer discretionary sector.

Large stocks can move the market when they put up monster gains, especially if you factor in sizable companies that fall outside the Magnificent Seven — such as Broadcom (NASDAQ: AVGO), which is now valued at more than $800 billion and is up more than threefold since the end of 2022.

MSFT Market Cap data by YCharts

The Magnificent Seven are so valuable that they can single-handedly spark a so-called correction in the S&P 500. A correction is a fall of 10% to 20% in a major market index, so an average decline of 28% in the Magnificent Seven would put the S&P 500 in correction territory. That math doesn’t even factor in sizable stocks like Broadcom that would likely fall in lockstep with a major sell-off in Nvidia and other tech stocks.

In this vein, the Magnificent Seven’s influence extends beyond their weight in the S&P 500. The group has been driving monster gains in the index during the past 18 months or so, but the larger it becomes, the more vulnerable the market will be to a growth-driven sell-off.

Expectations are high

No matter your investment time horizon or risk tolerance, it’s important to be aware of the S&P 500’s composition, especially when it undergoes a significant makeover. The index changes based on the economy’s evolution and investor sentiment. In other words, it’s a moving target, or benchmark, driven by different themes at different times.

Some investors might be nervous about the market’s relatively expensive price tag, with the S&P 500’s price-to-earnings (P/E) ratio sitting at almost 29. Even if the market rally is overextended, putting new capital to work — even at record highs — has historically been a winning strategy for investors.

There’s also a case to be made that the market deserves to be more expensive. If the S&P 500 grows earnings faster because the weighting of growth stocks increases, then it would stand to reason the P/E ratio should be higher as well.

Investing is more about where a company is headed than where it is today. And so far, mega-cap growth stocks have mostly delivered on earnings growth. For example, Amazon is still not terribly overvalued despite seeing its stock price more than double during the past 18 months.

A high P/E basically means that investors are willing to pay a higher price for a company relative to its earnings today because they expect earnings to be higher in the future. However, if growth slows and expectations come down, it can lead to a sizable sell-off.

The key takeaway is that the S&P 500’s valuation has become based increasingly on future potential earnings, whereas a few decades ago, the most valuable companies — consumer staples giants, banks, and oil and gas businesses — were valued more on their past earnings. Outsize gains could continue if companies deliver the growth that investors expect, but there could also be higher volatility in the market.

Build a portfolio that’s right for you

Given the expensive valuation of the S&P 500 and its puny 1.3% dividend yield, value- and income-focused investors could consider integrating quality dividend stocks and exchange-traded funds (ETFs) into a diversified portfolio.

As a starting point, Coca-Cola (NYSE: KO) and PepsiCo (NASDAQ: PEP) trade at discounts to the S&P 500, are both Dividend Kings (with over 50 consecutive years of dividend increases), and both have dividend yields of more than 3%.

The SPDR Dow Jones Industrial Average ETF (NYSEMKT: DIA) mirrors the performance of that index and has a 1.8% yield and a 23.3 P/E — making it a good option for folks looking to stick with blue chip stocks but through a value lens.

There are plenty of low-cost Vanguard ETFs that can provide a lifetime of passive income, such as the Vanguard High Dividend Yield ETF (NYSEMKT: VYM), Vanguard Consumer Staples ETF (NYSEMKT: VDC), and the Vanguard Utilities ETF (NYSEMKT: VPU). Targeting lower-growth, higher-yield sectors can be an effective way to balance a portfolio that is heavily allocated in growth stocks.

Adjusting with the times

At first glance, the market might look overvalued because the S&P 500 has an inflated P/E ratio. But that’s mostly because it is now heavily weighted in surging mega-cap growth stocks.

Plenty of pockets of the market are teeming with quality value and income stocks. Now is the perfect time for investors to conduct a portfolio review and update their watch lists to ensure they hit their passive-income goals while aligning their investments with their risk tolerance.

Don’t miss this second chance at a potentially lucrative opportunity

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Right now, we’re issuing “Double Down” alerts for three incredible companies, and there may not be another chance like this anytime soon.

See 3 “Double Down” stocks »

*Stock Advisor returns as of July 8, 2024

Bank of America is an advertising partner of The Ascent, a Motley Fool company. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Bank of America, Meta Platforms, Microsoft, Nvidia, Tesla, and Vanguard Whitehall Funds-Vanguard High Dividend Yield ETF. The Motley Fool recommends Broadcom and recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.

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