S&P 500's equity premium falls

Despite the S&P 500 falling by 23.9% during the first nine months of the year, the index appears more expensive based on one metric used by the Federal Reserve. The index's equity premium (the extra compensation investors require to hold stocks compared with risk-free bonds) stood at 5.03% in September, down from 5.65% at the end of 2021, according to data provided by the Fed. All else being equal, the price and equity premium move in opposite directions.

For instance, in March 2020, during the early days of the pandemic, the equity premium spiked to 8.34%. The central bank calculates the equity premium by subtracting expected real Treasury yields from the forward earnings-price ratio (the inverse of the price-to-earnings ratio).

Since October 1991, the median equity premium is 4.8%.

As the forward P/E fell, meaning the E/P rose, the increase in expected real Treasury yields caused the higher equity premium. In September, the S&P 500's forward P/E was 17.1 vs. 21.6 in December 2021. Taking the inverse of the P/E, the forward E/P increased to 5.8% from 4.6% in December.

In April 1999, during the dot-com bubble, the forward P/E was 25, or an E/P of 4%.