The S&P 500 Hasn't Yielded This Little Since the Dot-Com Bubble. Here's What Investors Can Do.

The S&P 500 (^GSPC 1.52%) yields just 1.2% at the time of this writing. According to data by Multpl, that is the lowest monthly reading since November 2000 when the S&P 500 yielded 1.18% -- before the sell-off in the Nasdaq Composite (^IXIC 1.88%) accelerated as the dot-com bubble burst. Many top growth stocks would go on to suffer brutal losses that took years or even over a decade to recover.

Here's what the S&P 500's current low yield says about the state of the U.S. stock market and what you can do about it.

Image source: Getty Images.

There's a clear explanation for the S&P 500's falling yield

With 500 holdings, the S&P 500 seems like a great way to invest in hundreds of top U.S. companies at once. But the index has become less diversified in recent years.

Just 4% of S&P 500 components make up 48% of the Vanguard S&P 500 ETF (VOO 1.53%), an exchange-traded fund that closely tracks the index. Since the S&P 500 is weighted by market cap, massive companies can really move the index in a way smaller companies cannot.

Single companies are now worth the equivalent of entire stock market sectors, or multiple sectors. Nvidia (NVDA 1.65%) plus Microsoft (MSFT 0.56%) make up more than the combined value of the materials, real estate, utilities, energy, and consumer staples sectors -- illustrating the top-heavy nature of the index.

The following table shows the 20 largest S&P 500 components by market cap and their dividend yields as I write on Aug. 18. The "weighted yield" column is the dividend yield multiplied by the percentage weighting in the Vanguard S&P 500 ETF -- which shows the impact each stock has on the index's yield.

Data sources: Vanguard, YCharts.

The key takeaway is that 48% of the S&P 500 contributes just 0.25% of the index's yield. Meaning that if you took out the 20 largest stocks, the S&P 500 would yield around 2% -- just like it did a decade ago.

So it's not that companies have stopped paying dividends, it's just that low- or no-yield megacap growth stocks like the "Ten Titans" now make up such a large share of the index that the overall S&P 500 yield is lower.

A justified rally

The S&P 500 and Nasdaq Composite underwent massive surges heading into the turn of the millennium that made stock prices go up faster than dividends. Similar to today's market, many of the top holdings in these indexes shifted to growth companies that prioritize reinvesting in their underlying businesses rather than distributing a portion of profits to shareholders through dividends.

The S&P 500's low yield illustrates the extent to which growth stocks dominate the stock market. But unlike the lead-up to the dot-com bust, this rally is much healthier because it is being driven largely by earnings growth and positive sentiment rather than euphoria.

Nvidia is a good example of a company with both a surging stock price and earnings that have compounded several-fold in just a few years. Investors aren't betting on what Nvidia could do in the future if everything goes right. Rather, they are betting on sustained momentum for what Nvidia is delivering right now.

As of Aug. 1, the forward price-to-earnings (P/E) ratio of the S&P 500 was 22.2 -- which is about a 20% premium to its 10-year average. However, the quality of the S&P 500's earnings and growth rate is arguably better today than over that 10-year average. So buying the S&P 500 still makes sense if you agree that the quality is worth paying up for. By this metric, the S&P 500 is pricey, but it's not remotely at nosebleed levels like we saw during the dot-com bubble.

Achieving a more balanced portfolio

The S&P 500 can still be a great tool for building long-term wealth. However, risk-averse investors may be looking for stocks at less expensive valuations and higher dividend yields.

The simplest way to counteract the S&P 500's premium valuation and low yield is to allocate other portions of your portfolio to help fulfill value and income objectives. That can be done by investing directly in top dividend-paying value stocks or value-focused ETFs.

It's important to understand what makes up the S&P 500 and let the index work for you rather than accidentally investing too much in the index and taking on more exposure to growth stocks than you're comfortable with.