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El-Erian Raises Concerns About GameStop 'Contagion' as Stocks Dip

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Mohamed El-Erian. (Source: Bloomberg)

The S&P 500 ended the first month of the new year in the red — down 1.1% — capping its worst week since October (with a 3.3% drop) and highlighted by a battle royal between day trading investors bullish on GameStop stock and hedge funds that have shorted the stock. The index closed Friday at 3,714.19 after dropping 1.9%.

“I predict a book on this, if not more, along with a movie,” Allianz Chief Economic Adviser Mohamed El-Erian tweeted Friday.

What is hard to call at this stage is the ending … not just for those directly involved but also for the broader asset prices, market structure, regulation & financial stability,” he said on Twitter.

U.S. stock markets have gotten caught up the GameStop drama, which eventually spilled into other retail stocks including AMC and Blackberry and led brokerage firms like Robinhood, Interactive Brokers, E-Trade and Webull Financial, to restrict some trading in GameStop and several other stocks this week, according to Wall Street Journal and Bloomberg reports.

In the meantime, hedge funds were selling other stock favorites like Apple, Netflix and Amazon to make up for their losses. Other factors affecting the markets this week included weak U.S. economic growth for 2020 and mixed news on vaccine efficacy.

The SEC announced it was “closely monitoring” the trading situation. The restrictions slashed gains in GameStop and some other stocks, but once they were lifted, the rallies returned.

Asked if the recent activity in GameStop shares bothered him, El Erian told CNBC on Thursday: “I am troubled because it is enabled by very distorted financial conditions.”

4 Key Market Factors

The four factors at play, he explained, are as follows: “One is the pure hedge fund versus retail and the establishment that doesn’t have broader market implication of financial stability. The second one is the change in market structure. The third one is the interest of regulators and politicians. And then the fourth one is the one that really has a lot of market implication.

“Is this the beginning of the accident we’re worried about because of over leverage, over excessive risk-taking? Or is this simply another buy-the-dip opportunity for market participants as hedge funds de-growth? That is the key element for your 401(k),” El-Erian said.

“The other stuff is really interesting, but the bottom line is do you believe this is the canary in the coal mine? Or is this yet another buy-the-dip opportunity?”

Regulatory Catch-Up

For El-Erian, the key is not to just “follow the money” but to focus on the risk. “Risk doesn’t disappear. Risk used to be in the banking system. … But the risk didn’t disappear. It morphed and it migrated to the nonbanks.”

However, the Federal Reserve doesn’t understand what’s happening in the nonbanks enough, he adds. “In general, that is not a sector that’s sufficiently understood. The regulators have got to do a massive catch-up.”

But Mark Mobius, formerly the head of emerging markets at Franklin Templeton and a GameStop investor, disagrees. 

“There definitely should not be any regulatory action,” Mobius said in an email interview with Bloomberg Thursday. “The regulator should only ensure that trading is done efficiently and fairly with all buyers and sellers (regardless of their objectives) treated equally.”

Market Contagion

To El-Erian, “The only game in town is be careful about the unintended consequences of relying for too long just on central banks. And … that’s why [Federal Reserve] Chairman [Jerome] Powell didn’t want to touch this [Wednesday],” he told CNBC.

Powell didn’t want “to go anywhere near” the GameStop trading “because he knows that this is a really complex issue,” according to El-Erian.

For investors, “You’ve got to worry about what are the consequences of distorting markets for so long? Let’s not forget that behind all the shorts of 100%-plus are rock-bottom interest rates and abundant liquidity, which means the cost of shorting, of leverage and availability of leverage are completely in the interest of the person wanting to leverage,” he explained.

As a result, “the likelihood of accidents is high,” he said. “Remember August, 2007, it started small. So keep an eye on this. I’m not saying this is the major market accident, but I’m saying that if you care about financial stability, you’ve got to look at this really carefully.” 

In his mind, what happened this week in the markets was contagion: “Remember the word contagion, because if you are in a losing position, if your broker’s calling you saying, ‘Hey, [about] your monitoring requirement, the margin call, you’ve got to make some cash.’ What are you going to do? You’re going to sell what you can sell. What do you sell? Your most liquid instruments?”

As a result of these sales, “the market as a whole gets hit, including the most popular names, because they’re the most liquid names,” El-Erian explained. “And then you have a few stocks that go up behind that are people covering their shorts and having to raise capital in order to do so.”

This series of events “is a typical contagion, with something small [over] here, creating something big [over] here. …  So keep an eye on this. It’s going to be fascinating the next few days, but [there's also] all the broader financial stability issues that we must not forget.”

Others market watchers agree. “Increased retail participation in equity markets is a typical side-effect of bull markets and of bull markets overshooting into bubbles,” Lars Kreckel, global equity strategist at Legal & General Investment Management, told Bloomberg Thursday.

“Should the result be restrictions on short selling, then this could be counterproductive in the medium term and make a bubble more likely,” Kreckel said. 

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