Mainstream financial advice has its place, and the S&P 500 is the go-to darling for a reason. The media attention drawn to index funds has sparked conversations, as everyone from around the world is using the S&P 500 as it’s bread and butter investment. But I can’t be the only one who’s thought: does it make sense for everyone to own the same 500 companies?

The S&P 500 is currently trading at around 22x+ forward earnings, about 30% above its 30-year average of 17x. Elevated? Yes. But what’s more intriguing than the valuation itself is the path that brought us here. Has passive index investing become so dominant that it’s quietly reshaping the market? Probably not, at least not yet. Index funds now hold roughly 16% of the U.S. stock market. That's a significant leap from nearly zero in the 1990s, but still not enough to point to full-blown bubble dynamics.

That said, the rise of passive strategies introduces a new kind of market behaviour: price-insensitive flows. When a stock is added to an index, funds don’t ask if it’s fairly valued, and buy it regardless of price. And when a name is removed, they sell, regardless of fundamentals. The result? Subtle but fascinating distortions, and a growing conversation around whether we’re witnessing the early stages of an “index fund bubble.”

JP Morgan’s “guide to the markets” illustrates well the forward P/E ratio over time, and should help investors determine whether the U.S. equity market seems over- or undervalued.

The current forward P/E (22.0×) is much higher than normal, considering the 30-year average. Values above +1 standard deviation suggest the market is significantly more expensive than its historical average, potentially supporting concerns about an overheated market or "bubble." Conversely, values below -1 standard deviation indicate the market is unusually cheap, and there are some good probabilities you will earn returns over time when entering below 17x.

P/E Ratios and Equity Returns: Does Valuation even Matter?

The short answer: yes, but only if you’re playing the long game.

Over a 1-year horizon, P/E explains just 5% of equity returns. In other words, markets are chaotic in the short term, and valuation barely registers. But stretch the horizon to 5 years, and the picture changes: P/E accounts for 13% of the variation in returns, a notable increase.

With today’s P/E hovering around 22x, long-term investors should temper expectations. High starting valuations tend to mean lower returns over the next 5 years.

As for the short term? Still as unpredictable as ever.

Mag 7 and its impact

The Mag 7 (Nvidia, Alphabet, Tesla, Microsoft, Amazon, Meta, and Apple) are definitely pulling more of the weight than the other companies the index is composed of. Here is why it matters:

If your bet is owning 500 companies, but seven of them control 30% of your returns, it distorts the intent. The Mag7 have grown so large that they've turned your S&P500 investment into a more concentrated tech bet. When these stocks move together, which they increasingly do, the entire index follows. The other 493 companies become background noise. Market cap weighting means that as these companies get bigger, index funds automatically buy more of them, creating a feedback loop where success breeds more success regardless of valuation.

The irony is: the strategy designed to eliminate stock-picking risk has concentrated your portfolio in the exact stocks everyone else picked. When investors discover they've been making the same bet as millions of others, usually during a downturn, the math of collective selling becomes uncomfortable quickly.

Bye wealth managers!

The index fund revolution has solved a very real problem: overpriced, underperforming active management. So that basically means saying bye to the underperforming wealth managers, and high fees. But like any elegant solution, it comes with trade-offs. Understanding those trade-offs isn’t a call to avoid index funds; it’s about knowing what you’re buying.

So, is there an index fund bubble? Unlikely. Are you probably overpaying for some of the companies within the index? probably. Does that make it a bad investment? Not necessarily. Still, could your money work harder elsewhere? Quite possibly.