In a recent Financial Times column, Mohamed El-Erian, former chief executive of Pimco, now president of Queens’ College, Cambridge, addresses this puzzle. El-Erian relates a scene from the film Shakespeare in Love, where a theatre 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 signalling a financial crisis.
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 toNovember before dropping 35%.) After all, people must invest somewhere.
Overcoming Obstacles
Such analysis is entirely in hindsight. That is an observation, not a complaint. Appreciating why the financial markets acted in a certain way 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 theatre 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.
