Hey savvy investors! There’s a saying in investing: take care of the downside, and the upside will take care of itself. That’s why I’ve been laser-focused on the risks posed by rising interest rates, and more recently, the risks of slower pace of rate cuts on REITs. But today, I want to talk about something else, something that’s been keeping me up at night. It’s a risk that I believe every investor should pay attention to, especially in today’s market environment.

What’s worrying me is valuations. Now, you might be wondering, aren’t REIT valuations still near historical lows, whether we’re looking at price-to-net asset value or dividend yields? Well, I’m referring to the high valuations in the U.S. stock market as measured by the Shiller PE Ratio. Because the U.S. market often sets the tone for global financial markets, including our Singapore REITs and dividend stocks. If the U.S. market falters, the ripple effects will be felt globally.

Before we dive in, I must let you know that this content is for informational and educational purposes only and does not constitute financial advice. The opinions expressed are based on publicly available information and personal analysis, and they are not tailored to your specific financial situation. The REITs and institutions mentioned are cited purely as examples. While I have no affiliations, sponsorships, or financial relationships with any of them, I may personally hold positions in some of the investments discussed.  Before making any investment decisions, you are strongly encouraged to consult a licensed financial adviser.

What is the Shiller PE Ratio and the Historical Trends

Let’s start with the basics: What is the Shiller PE Ratio?

The Shiller PE Ratio, also known as the cyclically adjusted price-to-earnings ratio or CAPE, is a measure of stock market valuation. It calculates the price of the stock market relative to the average inflation-adjusted earnings of the past 10 years. Unlike the regular PE ratio, which looks at just the past year’s earnings, the Shiller PE Ratio smoothens out earnings fluctuations caused by economic cycles. This makes it a more reliable indicator of long-term market valuation.

The key takeaway? A high Shiller PE Ratio means the market is overvalued, and historically, high Shiller PE Ratio levels have been followed by periods of lower market returns or even corrections.

Historically, the Shiller PE Ratio has ranged between 15 to 20 during periods of economic stability, with an average of around 16.5 since the 1870s. Whenever this ratio moves significantly above these historical norms, it often signals that markets are overvalued.

[Source: screenshot from https://www.multpl.com/shiller-pe%5D

Let’s examine three notable periods of high Shiller PE Ratio and their consequences:

1. Dot-Com Bubble in 2000:

The Shiller PE Ratio soared to an all-time high of 44, fueled by speculative tech stocks. Following this, the S&P 500 plunged by approximately 50%, wiping out trillions in market value over the next two years. It took several years for the market to recover to its previous highs.

2. Pre-COVID High in 2020:

In early 2020, the Shiller PE Ratio stood at 33, already well above historical norms. When COVID-19 triggered a global economic shutdown, the S&P 500 fell by nearly 35% in just a few weeks. Although markets eventually rebounded with government stimulus, the crash highlighted the risks of investing at elevated valuations.

3. Post-Pandemic Rally in 2021:

By late 2021, the Shiller PE Ratio climbed to 38, driven by a retail trading boom, stimulus-fueled liquidity, and ultra-low interest rates. But as the Federal Reserve began aggressively raising rates in 2022, the S&P 500 corrected by around 25%, marking the worst annual performance since 2008.

Why I’m Concerned About Today’s Market

As of now, the Shiller PE Ratio stands at approximately 38, one of the highest levels in history and on par with the dot-com bubble. What does this mean for investors?

Historically, when the Shiller PE Ratio exceeds 30, the subsequent 10-year annualized returns for the S&P 500 have averaged around 4% or lower, significantly below the long-term average of 8% to 10%. At current levels, the market is pricing in perfection, leaving little room for error.

The current high Shiller PE Ratio is worrying for a few reasons:

1. Global Correlations Matter: U.S. markets often set the tone for global markets. When U.S. stocks fall, Singapore REITs and dividend stocks, which are often seen as relatively defensive, aren’t immune. In fact, during 2022’s market correction, we saw stocks in Singapore take a hit alongside global equities.

2. Economic Resilience Masking Risks in the Horizon: While the U.S. economy remains strong, the stretched valuations mean that any unexpected shocks, whether geopolitical, economic, or monetary, could trigger a rapid market correction. While the global economy has been relatively resilient to events like wars in Ukraine and Israel, and U.S. bank insolvencies such as Silicon Valley Bank or SVB, there is no guarantee that the next shock won’t be the final straw.

3. Interest Rate Cuts Won’t Solve Everything: While many of us hope for more rate cuts to support markets, history has shown that overvalued markets can still decline even during periods of monetary easing. In addition, the market is now pricing in slower declines in interest rates due to potential inflationary factors.

But remember that this doesn’t mean a crash is imminent, but it does indicate a heightened risk of correction and lower long-term returns. Investors buying into the market now may need to temper their expectations and prepare for increased volatility.

Potential Strategies to Navigate High Shiller PE Ratio Levels

When the Shiller PE Ratio signals historically high valuations, it’s important for investors to adopt strategies that mitigate risks while staying ready for opportunities. Here are some practical approaches:

1. Focus on Quality and Fundamentals

During times of elevated valuations, prioritizing high-quality investments is key. This means looking for companies or REITs with strong fundamentals: healthy balance sheets, reliable cash flows, and competitive advantages that enable them to perform well even during market downturns.

For REITs, examples include Parkway Life REIT or CapitaLand Ascott Trust, which focus on more defensive sectors like healthcare or hospitality, benefiting from consistent demand and less cyclicality.

For dividend stocks, consider blue-chip stalwarts like NetLink NBN Trust, or Q.A.F. in Singapore. These companies are known for delivering steady dividend payouts and weathering economic turbulence better than high-growth names.

2. Dollar-Cost Averaging or DCA

Timing the market is notoriously difficult, even for seasoned investors. Dollar-cost averaging removes this uncertainty by allowing you to invest fixed amounts at regular intervals, no matter where the market stands.

By spreading your investments over time, DCA ensures you buy at both highs and lows, ultimately smoothing out your entry price. Even if you start investing now and the market later corrects, this strategy lets you pick up more shares at lower prices, effectively lowering your average cost.

The fact is, no one knows for sure how the market will behave, even when the Shiller PE Ratio is high. DCA ensures that your investment decisions remain disciplined and emotion-free, a critical advantage during volatile periods.

3. Hold Cash or Low-Risk Assets

Cash provides flexibility, enabling you to take advantage of buying opportunities during market corrections. However, I know from conversations with friends and fellow investors that many of us have low cash reserves right now.

Why? Because this year’s US tech rally and low REIT valuations have tempted us to deploy much of our cash. If this sounds familiar, it may be time to rebuild the cash portion of your portfolio.

Holding cash doesn’t mean sitting on the sidelines indefinitely. It’s about preparing for when valuations improve and opportunities become too attractive to ignore. Even legendary investor Warren Buffett has raised cash levels to historical highs in Berkshire Hathaway, signaling the importance of being ready for future opportunities.

4. Hedge Risks

Hedging is a valuable strategy to manage risks during uncertain times.

One option is to diversify into funds designed for downside protection, such as the Syfe Downside Protection Portfolio or Endowus Core Enhanced Funds with exposures to global systematic long/ short strategies. These funds aim to preserve capital during downturns while allowing some participation in market gains. And let me be clear, I’m not promoting these funds, but these features may be worth exploring.

For more affluent investors, hedge funds offer another avenue for managing risks, but these typically require higher capital and come with hefty fees. For regular investors, diversifying into less volatile assets like bonds, or gold could also help stabilize your portfolio. While these won’t eliminate risk entirely, they can act as a cushion during volatile market conditions.

The Dividend Uncle’s Take

So, what’s my take on all this?

I’m not here to say it’s the end of the world, or tell you to sell everything. But as investors, we need to recognize that the current high valuations in the U.S. market could have implications for our portfolios, be it REITs or direct U.S. stocks.

For me personally, this means doing these 3 things. One, continuing to focus on well-managed REITs and dividend stocks with solid fundamentals. Two, rebuilding my cash reserves, which have been depleted recently. I’m doing this by slowing down my non-DCA purchases and selectively selling shares that I believe have run slightly ahead of their fundamentals. This way, I’ll be prepared to take advantage of potential buying opportunities if the market experiences a correction. And three, I’m seriously contemplating reallocating part of my portfolio into funds that offer risk hedging with lower beta and higher Sharpe ratios for a more balanced risk-reward profile.

Remember, investing is a long game. While high valuations can create short-term risks, they also offer opportunities for disciplined investors who are prepared to act when the time is right.

Alright, folks, that’s it for today’s post. The Shiller PE Ratio is a powerful tool to gauge market valuation and potential risks. With the U.S. stock market looking pricey, it’s crucial to stay vigilant and prepared for whatever comes next.

What do you think about the current market valuations? Are you adjusting your portfolio in light of these risks, or are you staying the course? Let me know in the comments below. And if you found this post useful, don’t forget to like and subscribe to the website for more insights.

Thanks for watching, and until next time, happy investing!