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Hello investors! There's a popular saying in investing: Focus on the downside, and the upside will take care of itself. That’s why I’ve been keeping a close eye on the risks associated with rising interest rates and, more recently, the implications of a slower pace of rate cuts on REITs. However, today I want to discuss something different—something that’s been keeping me awake at night. It’s a risk I believe every investor should consider, particularly in the current market climate.
The concern? Valuations.
You might be thinking, Aren’t REIT valuations still near historical lows based on price-to-net asset value or dividend yields? True, but I’m talking about high valuations in the U.S. stock market, as measured by the Shiller PE Ratio. Since the U.S. market often sets the tone for global financial markets—including Singapore REITs and dividend stocks—any downturn in the U.S. can create ripple effects worldwide.
What is the Shiller PE Ratio?
The Shiller PE Ratio (also known as the cyclically adjusted price-to-earnings ratio or CAPE) is a tool used to assess stock market valuation. Unlike the regular PE ratio, which only considers the past year’s earnings, the Shiller PE Ratio factors in average inflation-adjusted earnings over the past 10 years. This helps smooth out fluctuations caused by economic cycles, making it a more reliable indicator of long-term market valuation.
Key takeaway: A high Shiller PE Ratio suggests the market is overvalued. Historically, high levels have preceded periods of lower returns or market corrections.
Historical Trends and Examples
Historically, the Shiller PE Ratio averages around 16.5. When it rises significantly above this, markets often become vulnerable. Here are three key examples:
Dot-Com Bubble (2000): The Shiller PE Ratio hit 44, fueled by speculative tech stocks. The S&P 500 then dropped by 50%, taking years to recover.
Pre-COVID High (2020): At 33, the ratio was already elevated. When COVID-19 hit, the S&P 500 fell by nearly 35% within weeks, despite a subsequent rebound due to stimulus measures.
Post-Pandemic Rally (2021): The ratio reached 38 amid a retail trading boom and low interest rates. As the Federal Reserve raised rates in 2022, the S&P 500 corrected by about 25%, its worst performance since 2008.
Why I’m Concerned About Today’s Market
Currently, the Shiller PE Ratio stands at 38-39, one of the highest levels in history. Historically, when this ratio exceeds 30, 10-year annualized returns average around 4% or lower, compared to the long-term average of 8% to 10%.
Three Key Concerns:
Global Correlations: The U.S. market often influences global markets. A U.S. decline can impact Singapore REITs and dividend stocks, which we saw during the 2022 correction.
Hidden Economic Risks: While the U.S. economy appears strong, high valuations mean unexpected shocks (geopolitical, economic, or monetary) could trigger a swift market correction.
Limits of Rate Cuts: Overvalued markets can still fall during periods of monetary easing. Plus, expectations for slower rate cuts add further uncertainty.
Potential Strategies to Navigate High Valuations
Focus on Quality and Fundamentals: Prioritize investments in companies or REITs with strong fundamentals, such as reliable cash flows and solid balance sheets. Examples include Parkway Life REIT and CapitaLand Ascott Trust for REITs, or NetLink NBN Trust for dividend stocks.
Dollar-Cost Averaging (DCA): Investing a fixed amount regularly helps reduce the risk of poor timing and smooths out your average purchase price over time.
Hold Cash or Low-Risk Assets: Maintaining cash reserves provides flexibility to seize opportunities during corrections. Even investors like Warren Buffett have increased cash positions to prepare for better valuations.
Hedge Risks: Consider downside protection strategies, such as funds with risk-hedging features, bonds, or gold. These assets can cushion your portfolio during market volatility.
My Take
I’m not predicting a market crash, but I am taking precautions. My strategy includes:
Focusing on high-quality Stock, REITs and dividend stocks.
Rebuilding cash reserves by slowing non-DCA purchases and selectively selling overvalued positions.
Exploring hedged investments for a balanced risk-reward profile.
Conclusion
The Shiller PE Ratio is a valuable tool for assessing market risk. With U.S. valuations at elevated levels, staying vigilant and prepared is crucial.
What are your thoughts? Are you adjusting your portfolio or staying the course? Share your insights in the comments, and if you found this helpful, don’t forget to like and follow!
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