His teaching has been around a while and yet not everyone agrees with him. Some follow other leaders and decide what they choose to believe in. Some think his teaching is flat-out misguided. I on the other hand, hang on every word and think about how I can apply it in my work managing client portfolios.
Of course, I’m speaking of Mohamed El-Erian. He’s the Chief Economic Advisor of Allianz, the global investment company. He’s been speaking out for some time about not trusting this market rise. In recent days he’s said this, “ I do not like betting on things I don’t understand”, and “I cannot predict the health progress (of Corona Virus vaccine) and I cannot predict moral hazard on the policy side”.
The definition of moral hazard is the lack of incentive to guard against risk where one is protected from its consequences. In other words, it is engaging in really risky behavior because you believe there will be no consequences if you screw up.
It surfaced this week that millions of amateur investors have become day-traders from the comfort of their COVID-19 confined living rooms. They are using a trading platform called Robinhood which is built around commission free trades.
Hertz stock was $1.45 per share last Friday and shot up to $5.61 on Monday of this week. This, while the company was already in a bankruptcy filing. Chesapeake energy stock was $12.80 last Friday and after announcing its bankruptcy filing was imminent, skyrocketed to $73.22 this past Monday.
It appears the retail investor has jumped into this market with both feet on the enthusiasm of states and municipalities opening-up from the Covid shutdown. It’s putting pressure on professional money managers to follow-suit.
Some professionals are afraid of being left in the dust by their amateur counterparts. They are deploying large amounts of cash in the market with the expectation that the Federal Reserve has their back. This is the moral hazard on full display. It’s like a casino game with the Fed (and other central banks) as the dealer. It’s just, they are looking at the cards before dealing them. In other words, they are controlling the outcome of the game.
The market has come to expect the Fed and Congress will continue to bail out the economy with paycheck protection money, enhanced unemployment benefits, low/no-cost loans to businesses, and even buying billions of dollars of investment assets on the open market. The Fed has driven interest rates to near-zero. They announced just today that is likely to be the case until at least 2022.
Since September, 2019 the Federal Reserve’s balance sheet (a.k.a their investment portfolio) has grown from $3.78 trillion to $7.16 trillion. Before the Great Recession of 2008 it was about $870 billion. The Fed is propping up markets and at some point this “easy money” from the Fed will break. Congress now wants to add more rescue money. At some point the government must let markets do what markets do. The healthy companies will survive and thrive, and the unhealthy ones will not.
Markets need to cleanse themselves every so often. That’s why it’s called a correction. It corrects for bad behavior, it corrects for bad luck and it certainly corrects for over-valuation of the companies that make up the market.
Since there is no end in sight for fiscal or monetary easing from the Fed, or the Congress, this market may remain propped-up the remainder of this year. That’s why we don’t want to be completely out of the market. I want to be “in” the market, just not, “all-in”.
I’m with Mohamed in that I’m not betting on the moral hazard either. I believe a healthy cash-position in each account makes a lot of sense. If you would like to discuss what “healthy” might look like in your portfolio, please reach out to me.
— Ron
Note: Stock price data sourced from Charles Schwab and Yahoo Finance. Our firm has not held a position in any stock mentioned and no positions are anticipated in the foreseeable future.
