Five Ways to Stabilize a Volatile Stock Market: El-Erian

The current bull market is just days away from becoming nine years old, given that the previous bear market came to an end with the close of trading on March 9, 2009. Many investors wonder how much longer it can go. Famed investor and market watcher Mohammed El-Erian writes on March 4, as printed in the Financial Times: "The particular sequence of the last month—abrupt correction followed by a rapid bounce back and then last week's pull back—raises interesting questions as to whether markets are in the initial phase of a prolonged sell-off or, instead, being placed on a stronger medium-term footing. The answer to that question will be answered by five factors."

Those five factors are: economic growth; monetary policy; the yield curve; volatility and liquidity; and investor complacency. The Investopedia Anxiety Index (IAI) records very high levels of concern about the securities markets among our millions of readers around the world. While the S&P 500 Index (SPX) has risen by 303% since the end of the last bear market, it is down by 5.0% from its high at the close on January 26, and up by just 2.0% year-to-date through the close on March 6. Meanwhile, volatility as measured by the CBOE Volatility Index (VIX) surged in January, adding to worries among investors who had gotten used to steady gains in stock prices.

Resume in Brief

A contributor to Bloomberg and the Financial Times, El-Erian is the chief economic adviser at Allianz SE, the parent company of asset management firm Pimco, where he previously was CEO and co-chief investment officer (CIO). Among other positions, he also headed the Global Development Council under President Barack Obama, was CEO of the Harvard Management Co., which invests that university's endowment, was a managing director at Salomon Smith Barney (later acquired by Citigroup, then sold to Morgan Stanley), and was a deputy director of the IMF, per Bloomberg.

1. Economic Growth

"Supported by pro-growth policies in the U.S. and a natural economic healing process in Europe, the global economy is in the midst of synchronized pick-up in growth," El-Erian writes. He is encouraged by the fact that consumption and business investment have been the major drivers of growth, rather than "financial engineering." Continued strong economic fundamentals are essential for the markets, he says, and he looks for the markets to be less reliant on liquidity from central banks in the form of asset purchases, or on liquidity from companies in the form of share buybacks, dividends, and acquisitions. He also believes that "growth can gain additional momentum if the world avoids a costly stagflationary trade war."

2. Monetary Policy

An upbeat sign for the U.S. economy, per El-Erian, is that economic growth has strengthened despite tightening by the Federal Reserve in the form of interest rate increases, announcements of future increases, and the cessation of asset purchases called quantitative easing. Indications that other leading central banks will follow a similar path also have failed to derail growth overseas, he notes. However, it remains to be seen, he adds, whether growth will persist "if the policy transition becomes more simultaneous [among]...several systemically-important central banks."

3. The Yield Curve

El-Erian sees a "relatively orderly" increase in bond yields that is reducing incentives for excessive risk taking. Moreover, he believes that the flat yield curve is primarily the result of "investment flows and bond issuance patterns," rather than forces that herald a "significant economic slowdown."

4. Volatility and Liquidity

He also finds it encouraging that volatility as measured by the VIX has increased to a more "realistic and sustainable range" than existed before the correction. Meanwhile, the recent implosion of exotic investment products linked to the VIX, as well as the interest shown by regulators in their failure, should remind investors of the importance of liquidity, he adds. (For more, see also: Stock Sell-Off Has Worrisome Similarities to 2008 Crisis.)

5. Investor Complacency

Another positive sign for El-Erian is that the return of volatility seems to have made investors less confident, and less certain that buying the dips will guarantee gains. In particular, the refusal of central banks to "immediately provide markets with comforting signals" during the correction gave a needed jolt to investor complacency, he adds. "Further progress on all five of these issues would put markets on a firmer footing and lower the risk of a much more dramatic and durable market sell-off," he concludes. (For more, see also: Why Stock Investors Can't Count on a Fed Rescue.)

Red Flags

Meanwhile, quantitative strategists at Bank of America Merrill Lynch note that 13 of their 19 "bear market signposts," or 68%, have been tripped, CNBC reports. These include economic, monetary, earnings and technical indicators, CNBC says, noting "Nearly all of them have usually been triggered before past bear markets."

Additionally, while sustained bear market declines of 20% or more are rare outside of a recession, the current bull market offers a more complicated picture, CNBC indicates, since stock valuations and stock prices raced ahead of the real economy, with stocks eventually becoming "over-owned and over-loved" by January of this year. Whether some over-compensation to the downside is long overdue remains a matter for debate.