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On Mohamed El-Erian's argument against market-timing

John Rekenthaler  |  11 Apr 2022Text size  Decrease  Increase  |  
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On January 27, I published “The Stock Market’s Dominoes Are Falling.” The article outlined how US equities were displaying the textbook signs of a bear market, by collapsing from the outside. First to suffer were the most-speculative securities, such as special-purpose acquisition companies and emerging firms that lacked earnings. Then fell the high-priced glamor companies, such as Meta Platforms (FB) (formerly Facebook) and Tesla (TSLA). Would the rest of the marketplace follow?

For once, my timing wasn’t unintentionally contrarian; by early March, the S&P 500 was down an additional 4%. And the dominoes kept on falling. Despite the geopolitical worries and economic disruption caused by the Russia-Ukraine conflict, the stock market has since righted its ship. The index now trades slightly higher than on the day my article appeared.

Such behaviour, of course, baffles those who don’t invest. The stock market not only sometimes celebrates what Main Street views as unhappy news, such as rising unemployment (which can benefit equities by reducing the possibility that the Federal Reserve will raise interest rates), but it also anticipates future events, which confuses those accustomed to thinking in the present. In 2020, for example, the US stock market bottomed on April 7--only one month after the novel coronavirus arrived, and long before the economy felt the worst of its effects.

The current mini-rally, though, has been hard for even investment professionals to explain. It would be one thing if stocks’ decline had occurred because of an expected Russian invasion. But that clearly was not so. The selloff started before Russian-Ukraine relations cratered. Nor was the war a foregone conclusion. In a January 2022 poll, 56% of foreign-policy experts predicted that Russia would attack Ukraine during the next 12 months, with 44% either demurring or unsure. The assault could not have been fully incorporated into stocks’ prices.

The expert’s view

In a recent Financial Times column, Mohamed El-Erian, former CEO of Pimco, now president of Queens’ College, Cambridge, addresses this puzzle. El-Erian relates a scene from the film “Shakespeare in Love,” wherein a theater owner declares that although his business constantly courts disaster, “strangely enough it all turns out well.” When asked why, he responds, “I don’t know, it’s a mystery.”

Being a researcher rather than an artist, El-Erian promptly attempts to solve the mystery that faces him, by understanding why stocks have regained their footing. One reason, he writes, is the strength of the US economy. It is true that inflation has soared, which doesn’t help equity prices. On the other hand, US corporate profits rose by 26% in the fourth quarter of 2021, on a year-over-year basis, with consumer demand remaining robust. (Although corporations quite naturally dislike paying high wages, doing so does increase demand for their products and services.)

Another explanation is that, despite inflation, commodities shortages, and the economic sanctions on Russia, the world’s financial system isn’t stressed. El-Erian cites Goldman Sachs’ Financial Conditions Index, which examines global interest rates, credit spreads, exchange rates, and equity valuations to determine whether money is relatively easy or relatively tight. Although up sharply from its summer 2020 levels, when central banks were highly accommodative, that index remains only slightly above its 10-year average. It is not signaling a financial crisis.

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His final justification is the familiar refrain that stocks might be bad, but other investments are worse. “[Equities] seem less dirty than the guaranteed negative real return on cash due to high inflation; highly volatile commodities and cryptocurrencies; and bonds that remain vulnerable to further price drops.” (He has a point about cryptocurrencies, as bitcoin doubled from July through November before dropping 35%.) After all, people must invest somewhere.

Looking forward

Such analysis is entirely in hindsight. That is an observation, not a complaint. Appreciating why the financial markets acted as they did forestalls rash decisions. Indeed, I would argue that the largest benefit from studying financial history is not to learn which assets have performed best--that information may quickly be learned--but instead to develop a tolerance for the marketplace’s bumps. Better to be reflective than angry, frightened, or confused.

However, El-Erian does follow his diagnosis with a prescription: “Better than to continue to bet heavily” that the stock market, like the theater business, will somehow overcome its obstacles, “it would be wise to make the most of the strength of equities and take some chips off the table.” Where those monies should go, El-Erian does not specify, aside from recommending private equities to those who can afford them. Presumably, retail investors should hold cash.

This advice, I submit, does not follow from El-Erian’s previous argument. He acknowledged that although equities continually face daunting obstacles, they usually find a way to advance, thereby confounding the expectations of contemporary observers. El-Erian himself has been one of those observers. Along with the rest of us, he wondered during the early days of the Russia-Ukraine conflict what that would do to global markets. He now possesses that answer.

However, he does not know what will happen next. Therefore, when El-Erian advises today’s investors to reduce their equity exposure, he cannot be sure they will be able to reinvest their proceeds at lower prices. Perhaps stocks have already touched their 2022 lows. If so, those with cash in their pockets may become mired in a “bear trap,” by being perpetually underinvested, awaiting a stock-market sale that never arrives.

My conclusion: Some investors do hold too much equity, thanks to the past decade’s sharp rise in stock prices. Such shareholders would do well to heed El-Erian’s recommendation to lighten their portfolios. But those trades should be strategic, not tactical. As El-Erian himself suggests, the stock market’s mysteries only unravel after the fact. Understanding the past helps prevent future investment mistakes, but such knowledge rarely, if ever, bestows investment triumphs.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

is vice president of research for Morningstar.

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