In the first part of this article, we’ve talked about the S&P500 index in general and the current, somewhat paltry yield. Funny thing is, when you look at the actual stocks in the index, things look a little brighter.

Here are the top 10 stocks and dividend yields in this market cap-weighted index:

Note that almost all of these stocks pay larger dividends than the S&P500 as an index (1.7%). How is this possible, when these stocks make up some 20% of the index?

What we’ve seen is a near flip-flop of the market in 2000. Back then, all the mega-cap stocks traded at such lofty valuations that dividend yields were slim. Worse, from a dividend point of view, tech and growth stocks with no dividends topped the charts, so to speak. The smaller stocks in the S&P500 were actually cheap, and many had far-above-market dividends.

Since 2000 the smaller-cap stocks in the index (which are really more like mid-cap stocks, given that few really small-cap stocks are in the S&P500) have raced up (many have more than doubled), while the mega-cap stocks fell, often by as much as 50%. Some more stable tech stocks, like Microsoft (MSFT), started paying dividends.

Now the more expensive smaller stocks in the index are weighing down the dividend yield of the index. You can tell something happened along these lines by looking at funds over the last few years.

Small-cap funds have killed the S&P500 – many have doubled while larger-cap-oriented funds are largely flat or down – still.

An equally weighted S&P500 index really shows the action of the last few years. Keep in mind the S&P500 is market cap-weighted, meaning when you put $1,000 into the Vanguard 500 Index (VFINX), about 3.2% or $3.20 of your money goes into General Electric (GE), while only 0.02% or $0.20 goes into Goodyear Tire & Rubber (GT). No wonder mega-cap stocks were overpriced in 2000; everybody was piling into them through index funds.

With an equally weighted index, every stock in the S&P500 gets the same weight. If you put $1,000 into this retooled index, each holding gets a 0.20% allocation, or $2.00. Doing so means smaller-cap names get larger allocation than they “normally” would, while larger-cap names get a smaller allocation.

According to Standard & Poors, the equally weighted index is up 78% over the last seven years. The normal, cap-weighted index is up just 13%. More startling, if you invested in the equally weighted index at the top of the market bubble in 2000, you’d be up over 50% today, while you’d still be down in the traditional index. Same stocks, totally different returns if re-jiggered. Of course, nobody offered an equally weighted index fund in 2000 (that came years later, after it was a good idea…).

It was a little over five years ago when I penned my anti-indexing tome, “Index Bomb: A Popular Investment Theory Knocks Markets Out of Whack”. The article ended with “Maybe someone should start a fund that shorts the top 50 stocks in the S&P 500,” meaning that mega-cap stocks were overvalued back then.

While valuations today are not so favorable for large-cap over small that you should short smaller-cap stocks, investors will do better over the next five to ten years in mega-cap stocks (though we’ve cut back on our own small-cap stakes in our PowerPortfolios).

The S&P500 and the Dow are not bad ways to go, but investors should seek out mega-cap-oriented funds – the exact opposite of what would have worked in 2000. Since investors want maximum dividend yield, we’ve chosen the cheapest ways to own these stocks (fund fees come out of dividends first).

Some to consider:

Bridgeway Blue-Chip 35 (BRILX) – a no-load fund with an expense ratio of 0.15%
iShares S&P 100 Index (OEF) – an ETF with a 0.20% expense ratio
Rydex Russell Top 50 (XLG) - an ETF with a 0.20% expense ratio
Market 2000 HOLDRs (MKH) – essentially a basket of the largest stocks by market cap circa 2000 (a few are now much smaller, as they crashed and burned. HOLDRs must be purchased in 100-share lots)

Let’s assume investors are going to earn 6% over the next five to ten years in stocks. By our logic, small to mid-cap investors may see as little as 4%, and mega-cap investors 7% to 8%. A cap-weighted S&P500 should beat the equally weighted S&P500 index going forward.

Keep in mind that no dividend analysis or relative valuation model makes stock investing risk-free. With investing, you can be right and still lose a fortune. Our biggest fear – as we’ve sold all our micro-cap funds and are buying mega-cap funds in our PowerPortfolios – is that we’re only halfway into the small-cap-kills-large-cap trend. Who is to say small-cap stocks won’t get even more ridiculously valued and trade with average yields of 0.50% and P/Es of 40, much like mega-cap stocks did in 2000?

Vanguard Small Cap Index (NAESX) currently yields 1.08% while their 500 Index (VFINX) fund yields 1.71%. Even more surprising, Vanguard Small Cap Value Index (VISVX) yields just 1.97% – barely above the 500 Index, which has more growth-oriented names as well. Small-cap is fully valued. The only question is whether small is going to get insanely valued before it tanks. We’d still favor larger-cap.