Mom-and-pop investors are watching their account balances grow as the stock market has surged over the last few months. While this happens, Mohamed El-Erian, the chief economic adviser at Allianz, is worried.
“It is hard to overstate the extent of today’s risk-taking in US financial markets. Dramatic single-name surges (think Apple and Tesla) have amplified stocks’ continuous march higher,” El-Erian writes in a recent op-ed for the Financial Times.
He says the ease of trading today, with apps like Robinhood, has created a new wave of day traders. These day traders think stocks only go up.
“Retail investors have been flocking to equity markets as an unrelenting five-month surge in valuations suggests stocks are immune to the damage being inflicted on the economy by the Covid-19 pandemic.”
El-Erian on the Economy and Stock Market
El-Erian feels worried that this surge has many retail investors believing that the entire investing community became bullish on the stock market.
“The seemingly endless rally in US stocks gives the impression that prices are endorsed and supported by the entire professional investment community.”
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But El-Erian points out that the economy and stock market are two different things. He also says “corporate and economic fundamentals have yet to reflect a sustained and convincing recovery from Covid-related damage.”
“The bounce in consumption is moderating. Initial US jobless claims are back at the one million level for a second straight week,” he adds. “The recovery in mobility, retail traffic and other high-frequency indicators has eased. Bankruptcies are rising. And with Congress yet to agree on a new relief package, the risks are rising that short-term disruptions will become deep, long-term scars.”
Sophisticated investors understand this. They have been hedging their bets while retail investors continue to gorge themselves at the buffet of un-ending profits.
Instead of going long and buying stocks, these investors are using derivatives like call options to reduce their risk. They do so while also benefiting from any rise in prices along the way.
Bets on Volatility
Sophisticated investors are also increasing their bets on volatility in the markets. They’re doing so to protect their portfolios should the market experience a quick drop. El-Erian says the VIX, the measure of volatility, has “decoupled from equity indices.”
He adds that this is another signal that if the market does drop in the near future, the number of sophisticated sellers that would be quickly exiting the markets would “overwhelm the buy-the-dip retail investor.”
“Yes, it would take a big shock for markets to move significantly lower — such as a renewed sharp economic downturn, a considerable monetary or fiscal policy mistake, or market defaults and liquidity accidents. But should such a move occur, the likelihood of further market turmoil would be high, especially given the current lack of a short base to buffer the downturn.”
El-Erian says this rapid and deep correction would leave retail investors flat-footed. They will also likely experience large losses as it spills over into the economy.
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“This exposes small retail investors to big potential losses. It risks broader economic damage and could end up pulling central banks even deeper into distorting price signals and undermining the markets’ role in efficiently allocating resources throughout the economy.”