EL-ERIAN: The Market 'Sucking Sounds' Are Getting Louder As Four Forces Come Together

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Mohamed El-Erian

As commentators focus on this early morning’s price action, including some notable gapping dynamics, investors are well advised to keep an eye on underlying market liquidity. The “sucking sounds” of prior days are getting louder as four factors come together. And while not a "Lehman Moment," investors should be careful as such nasty market technicals can feed onto themselves.

Dislocated liquidity conditions -- as in wider and more volatile bid-offer spreads, considerably less intermediation appetite among dealers, etc. -- are cascading down from the most levered market segments. The direct and immediate causes are:

Greater market volatility forcing more formulaic and VAR-based accounts to reduce positions in an accelerated fashionCrossover investors trying to get back to their “home asset classes,” and finding it hard to do so in an orderly fashionAn outflow of funds from mutual funds and other accounts; and, of course,Reduced willingness among dealers to make markets and, in the process, resisting to hold much inventory

In essence, the liquidity underpinnings of markets can no longer support the overall positioning of investors overly comforted by the prolonged and repeated interventions of hyper active central banks using experimental policies. 

Determining whether this is just a temporary blip or what economists call a “multiple equilibrium” (i.e., rather than mean revert, an unpleasant outcome increases the probability of a subsequent worse outcome) is essentially a call on two main issues: the health of the underlying fundamentals relative to market pricing, and the availability of balance sheets to step in with stabilizing liquidity.

Given current indicators, this periodic phase of dislocation in market liquidity -- and they do occur occasionally -- is likely to continue in the immediate period ahead. 

In the process, look for some attractive pockets of value to emerge.

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To embed this post, copy the code below and paste into your website or blog. Dr. Mohamed Abdulla El-Erian is the CEO and co-CIO of PIMCO, the world’s largest bond investor with over US$1 trillion of assets under management as of 2010. El-Erian previously worked as the investment manager of Harvard... More »

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