MorningWord 5/4/16: El Erian’s Trade Deadline

by Dan May 4, 2016 9:49 am • Commentary

Interesting read from Mohamed El-Erian, the chief economic adviser to Allianz:

Usually when El-Erian writes on macro, much of it is above my pay-grade. But this morning, he is speaking my language (emphasis mine):

Up until recently, market participants had been universally conditioned to rely on central banks to shield them from all this fluidity via unconventional policies that repress financial volatility. This well-rewarded faith, at least until now, is starting to be challenged by the difficulties that the Bank of Japan in particular is having in delivering the desired financial outcome.


Despite all these developments, measures of both realised and implied volatility have narrowly fluctuated at notably low levels in recent weeks. To understand this relative market calm, one has to appeal to three phenomena.


First, after somewhat of a relative pause earlier in the year, cash-rich companies have injected more of their surplus funds back into the market via higher dividends, share buybacks and stepped-up M&A activities. Second, corporate earnings have tended to beat consensus market expectations that have been skilfully managed down by companies facing the biggest earning pressures since the global financial crisis. Third, the “trend is your friend” mindset remains an important determinant of general market behaviour, especially given earlier volatility head fakes.

El-Erian goes on to say that investors should expect greater volatility in the future, and this period of relative calm offers investors the opportunity to do a little risk mitigation as he calls it:

With lower volatility offering a window of greater market liquidity, this is a good time to trade up in quality, focusing in particular on names that offer strong balance sheets.

And here is the part that surprised me, much the way that legendary hedge fund manager Stan Druckenmiller’s comments last November surprised me about a specific group of stocks:

The best candidates for buy and hold strategies are those that combine growing platforms with content that is driven by the powerful combination of technological innovation, consumer empowerment, mobility and behavioural science. While the ride will involve liquidity-induced rollercoaster moments, this speaks to the continued long-term attractiveness of companies such as Alphabet, Amazon and Facebook.

It’s really the last sentence, the long term attractiveness of companies like GOOGL, AMZN, and FB. Three companies that dominate their respective businesses from a revenue and profit standpoint, have near monopolies in terms of market-share, which investors have been more than willing to pay sky high valuations for, regardless of the market conditions over the last year. These three companies had about $185 billion in 2015 sales, with a collective current market cap of $1.1 trillion (nearly double that of a year ago).  The financial markets have seen this sort of market cap concentration in only one period before, and that was in the lead up to the top of the tech bubble in 2000 when Cisco (CSCO) and Microsoft (MSFT) had a combined $43 billion in trailing sales and close to a $1 trillion in combined market cap. Both stocks saw precipitous drops, with CSCO declining about 90% and MSFT about 65% from their 2000 peak to their 2002 low (with the Nasdaq Composite dropping nearly 80% from its peak to its 2002 trough).

Nasdaq Composite 20 year chart from Bloomberg
Nasdaq Composite 20 year chart from Bloomberg

I’m not suggesting that AMZN, FB & GOOGL are about to experience a sharp drop. But the near universal optimism for these companies and general disregard for valuation by investors sets up for broader market induced surprise at some point. And it may be in the not so distant future if El-Erian and others are right about the increasing ineffectiveness of the major driver of risk asset prices and the major dampener of volatility, central banks.