S&P 500 Risk Premium

Why is this important?

The Equity Risk Premium represents the excess return that investing in the stock market provides over the risk-free rate (10-Year Treasury). It is a fundamental metric for valuation at the index level — the higher the spread, the more investors are compensated for taking on equity risk.

What is occurring?

The spread has turned negative, denoting very expensive valuations. Note that this model relies on trailing earnings without dividends, making it a backward-looking diagnostic. While useful for historical baselines, see Model 02 below for a comprehensive, dividend-adjusted view.

Synopsis

The blue line shows where the ERP ends each year and how it correlates to the following year's S&P 500 returns. The higher the ERP, the better the returns tend to be. In the modern era (last 20 years), valuations have been range-bound between 4%–6% ERP.

During the Dotcom bubble, the ERP fell to very low levels — reaching a low of 2.05%. Elevated valuations can persist in shorter time frames, but once these periods end, market valuations mean revert. From the close of 1999, it took the S&P approximately 7 years to make new highs.

What is occurring?

This chart shows a one standard deviation move over/under the 30-year average forward earnings multiple for the S&P 500. The current forward P/E ratio is stretched against historical precedent. The only other period where the forward P/E traded at a higher ratio — near 25x forward earnings — was in late 1999. The most recent occurrence where the index traded over 22x forward estimates appeared in late 2021, in what I have dubbed the "MEME" stock bubble.