El-Erian: Three Lessons for Investors in Turbulent Markets
By Mohamed A. El-Erian
The global stocks roller-coaster of recent days reminded me of three lessons I learned many years ago as an investor in emerging markets. If well understood and applied, these precepts can turn unsettling volatility surges into longer-term opportunities.
- Long periods of market calm create the technical conditions for violent air pockets. Until last week, the most distinctive feature of many market segments was historically low volatility, both implied and realized. Although several economic and corporate reasons were liberally cited for this development (including the convergence of inflation rates worldwide and eternally supportive central banks, as well as healthy balance sheets and synchronized growth), an important determinant was the conditioning of the investor base to believe that every dip had become a buying opportunity, a simple investment strategy that had proven very remunerative for the last few years.The more investors believed, the greater the willingness to “buy the dip.” Over time, the frequency, duration and severity of the dips diminished significantly. That reinforced the behavior further.
The economist Hyman Minsky had a lot to say about the phenomenon of prolonged stability breeding complacency as a precursor to instability. This phenomenon is reinforced by the insights of behavioral finance and can lead markets to embrace paradigms that ultimately prove unsustainable and harmful (such as the idea well more than a decade ago that policy making had totally overcome the business cycle, and the notion that volatility had been flushed or hedged out of the financial system).
- Crowded trades can be a lot more unstable than most investors expect. This was the case this week with what are known as short-volatility trades, which come in many forms.Some were explicit, such as buying products that return the inverse of a volatility index like the VIX. Others were constructed via combinations of puts and calls in derivative markets. Others still were implicit in some of the extreme positioning among institutional investors, such as taking large off-benchmark exposure in high yield and certain segments of emerging markets. And all of this reflected a willingness of investors to give up an unusual amount of liquidity, and to do so while being compensated little relative to history.
Initially, these trades became more and more stable, and handsomely rewarding, as more investors and traders embraced them. This made the opposite positioning — being long volatility — very costly to hold. With that, John Maynard Keynes’ observation proved correct: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Under such conditions, it should come as no surprise that the unwinding of crowded trades can be extremely unsettling for markets as whole. Prices gap lower, liquidity erodes and those in distress scramble for indirect hedges, as imperfect as these may be.
- During market turmoil, investor differentiation gives way to indiscriminate action. As explained by the “market for lemons” theory put forward by George Akerlof, and by the work of Nobel Laureates Michael Spence and Joseph Stiglitz, it becomes very difficult to signal “quality” when the context is extremely noisy and volatility is unsettling. In violent market selloffs, even solid names get treated as “lemons” initially. Then, provided investors can underwrite volatility, comes the best of all market bargains: picking up at cheap prices stocks and bonds issued by fundamentally solid entities, both private and public, with strong balance sheets, limited debt and favorable growth prospects.
All three of these lessons are relevant to the recent market movements, which have been technically driven, and not by economic and corporate fundamentals. Indeed, these gyrations occurred in the context of improving, and not deteriorating fundamentals. And they have served to partially close the gap between elevated asset prices and what had been more sluggish fundamentals.
The market turmoil will likely lead to a healthier resetting of investor conditioning and, one hopes, greater respect for volatility and the importance of proper pricing of liquidity. After all, as Warren Buffett observed, “Only when the tide goes out do you discover who’s been swimming naked.”