Having resigned in March from his risk-product-promoting-Pimco duties, Mohamed El Erian is now speaking more urgently on the capital risks of QE’uphoric asset prices of late. See his article today: What if the Fed has created a bubble.
“…the Fed has been pushing stock and bond prices up to “bubblish” levels, in the expectation that they will inspire the kind of consumer spending, physical investments and hiring required to subsequently justify them. The hope is that the convergence will occur in the context of full employment and inflation near the Federal Reserve’s target of 2 percent. So far, though, the wedge between asset prices and economic reality remains large, as last week’s juxtaposition of new stock-market highs and still-anemic wage-inflation data demonstrated.
The danger is that the economic recovery will ultimately fail to validate artificially high asset prices, leading to significant financial instability and adverse “spillback” for the economy. The more comfortable the authorities are in their ability to counter — and, if necessary, contain — such potential instability, the greater their appetite for maintaining the stimulus that markets so love.
…Macro-prudential progress, while notable, has fallen short of what national authorities initially envisaged, and international coordination has fallen short of what is needed to make it all work globally. Investors would be well advised to take this into consideration in making their Fed-driven trades, especially if they involve positions that will be difficult to sell or unwind in more volatile markets.”
Having re-joined PIMCO at the end of 2007 after serving for two years as president and CEO of Harvard Management Company (the entity that manages Harvard’s endowment) just before it’s highly levered portfolio imploded with asset bubbles in 2008-09, it seems El Erian is hoping to stand more clear of capital carnage in the next mean reversion cycle.
This Forbes article from February 2009 offers a useful reminder of aggressive mistakes that El Erian and most other managers and investors/speculators made in the run up to the 2007-09 meltdown…sounds very familiar to present mainstream thinking and “genius” strategies. Food for thought. See: How Harvard’s Investing Superstars crashed.
“El-Erian…talked of the “structural advantages” of investing a big endowment backed by an AAA-rated university, such as allowing you to borrow at low rates when making leveraged bets. The former Pimco emerging-market superstar also believed that the developing countries offered big profits to smart investors like HMC because they had become less risky thanks to ample dollar reserves and a growing middle class.
El-Erian upped HMC’s exposure to emerging-market stocks, which rose from 6% of assets when Meyer left, to 11% two years later. He also used total return swaps to bet on developed world stocks and commodities on the cheap, freeing up money for other investments. Tapping former Stanford endowment staffer Mark Taborsky (an “important hire,” El-Erian would later write in a book), El-Erian also took money from hedge funds he didn’t like and redirected it to ones he thought were winners, putting hundreds of millions into funds in Latin America, Asia and the Middle East.
The moves looked brilliant. For the year ended June 2007, Harvard returned 23% versus 17.7% for 151 other big institutional investors (and 20.6% for the S&P 500). Fearing all markets could soon fall, El-Erian injected what he referred to as “Armageddon insurance” into HMC’s portfolio for the first time by buying interest rate floors, or a wager that rates would fall, and betting, via credit default swaps, that companies could soon struggle to pay their debts.
For the following year, through June 2008, Harvard gained 8.6%, versus a 13% fall in the S&P. El-Erian’s insurance accounted for much of HMC’s outperformance. Hedge funds, however, were sucking up cash–HMC had increased investments in those areas to 19% from 12% a year earlier. The returns were flat. It’s unclear how much of the results–good or otherwise–were El-Erian’s doing. He left at the end of 2007, six months before the results came in, citing a desire to move back near his wife’s family in California and return to Pimco as heir apparent to founder Bill Gross.
Since July, emerging-market shares have been a disaster, falling 50%, as measured by the MSCI Emerging Markets Index, worse than U.S. stocks. Another problem: El-Erian’s insurance has been partly taken off since he left, leaving HMC vulnerable when markets plunged this fall. The total return swaps, which easily could have been terminated, were left alone. The EFG-Hermes Middle East North Africa Opportunities Fund, a hedge fund launched in September 2007 with some $200 million of HMC cash, was down 35% in 2008. El-Erian’s big hire, Taborsky, left HMC in September. He’s since joined El-Erian at Pimco. El-Erian and Taborsky decline to comment.”
The Harvard Endowment Fund ended up losing some 30% in the downturn of 2008-09 and has spent the past 5 years recovering…