Four things that could pop the ‘rational bubble’ in equities: Mohamed El-Erian

There’s been a lot of hand-wringing about the stock market rally. With major averages consistently making new records, the S&P 500 up another 1.5% after last year’s 16% gain, and the seemingly bottomless appetite for IPOs and SPACs (Special Purpose Acquisition Company), investors want to know: What could bring stocks tumbling down?

Mohamed El-Erian thinks the path of least resistance continues to be upwards as equities float along in a “rational bubble,” a phenomenon outlined in a Financial Times article earlier this year.

But there are four risks to the continued rally. El-Erian, the president of Queens College at Cambridge University and the Chief Economic Adviser to Allianz, outlined those risks in an interview with Yahoo Finance Live.

First, the least likeliest risk is that the Federal Reserve would pull back on its monetary stimulus. But as Fed Chair Jay Powell said just Thursday in a webinar, “Be careful not to exit too early.”

El-Erian thinks while the Fed’s public-facing reason for keeping the taps open is concern over a tenuous economic recovery, there’s a less explicit reason as well: “They don’t want to repeat the taper tantrum,” he said, referring to the sharp spike in bond yields in 2013 following commentary by the Fed that it would begin to taper stimulus.

“They are concerned that higher yields will change the appetite for stocks,” El-Erian said. “They don’t want volatility in the stock market to undermine the economy.”

So, no tapering for now.

NEW YORK, NY – APRIL 29: Mohamed El-Erian, Chief Economic Adviser of Allianz appears on a segment of "Mornings With Maria" with Maria Bartiromo on the FOX Business Network at FOX Studios on April 29, 2016 in New York City. (Photo by Rob Kim/Getty Images)
Mohamed El-Erian, Chief Economic Adviser of Allianz. (Photo by Rob Kim/Getty Images)
The next risk: a wave of corporate bankruptcies. “That’s going to happen to some extent, but not enough, I think, to change behavior in markets,” El-Erian said. Indeed, more than 600 companies filed for bankruptcy last year, including well-known consumer names like Lord & Taylor and CEC Entertainment, the parent company of Chuck E. Cheese. But stock markets remained unfazed.

The last two risks could be more, well, risky.

There could be “some sort of market accident. We are seeing a lot of risk taking,” El-Erian pointed out. This harkens back to the crash of 1999, when valuations of tech startups soared, then crashed, as investors were willing to pay elevated prices for future estimated growth.

Some investors see echoes of that dot-com bubble today, with a record fourth quarter for IPOs whose momentum continues into 2021. Lender Affirm went public on Wednesday, its shares nearly doubled. Shares of Poshmark, an online marketplace for second-hand goods, are up more than 130% in its debut Thursday.

To monitor the final risk, watch the bond market.

“If we were to see another 20 basis point move in yields, that would be bad news,” El-Erian said.

That’s because one of the driving forces behind the equity rally is the idea that “there is no alternative,” frequently referenced by its acronym, TINA. If bond yields move up more meaningfully, that might provide an attractive alternative to stocks.

Investors can keep an eye on these risks while still recognizing stocks will probably continue to rise.

“To be clear, the path of least resistance right now is higher,” El-Erian said.