The upside of current market turbulenceJune 12, 2013: 5:00 AM ET
As some prices overshoot in the downward direction, as they inevitably do, investors will come across opportunities that they previously could only hope for.
By Mohamed A. El-Erian
FORTUNE -- Liquidity shocks, like the one currently cascading through global financial markets, are unpleasant, and frustrating. They can be indiscriminate in their impact, as is the case today. They are hard to explain rationally and, as such, can become incapacitating. Yet, they often create interesting opportunities for those that understand the underlying dynamics and know where to look.
Here is a simple way to think about the phenomenon. Suppose we are sitting in a room where the oxygen is suddenly sucked out. It is likely that we will ALL eventually end up on the floor gasping for air, and this will occur regardless of our initial physical condition (a key point). Yet this uniformity of physiological response will likely not persist once the oxygen is gradually restored (and provided it doesn't take too long). Some will recover relatively quickly. Others will face more prolonged challenges. And a few may never recover.
Well, that is how financial markets work when there is a sudden and substantial withdrawal of liquidity. The situation is remedied in two ways: The horrid market technicals eventually exhaust themselves and/or market participants with healthy balance sheets (private, public, or both) step in to provide stabilizing liquidity.
In the meantime, you get what economists call an adverse multiple equilibrium -- rather than mean revert, a bad outcome increases the probability of an even worse subsequent outcome. So markets overshoot on the downside beyond what would be warranted by fundamentals; and such overshoots can be considerable in the context of excessive market exuberance going into the liquidity implosion.
Over the past few weeks, we have been monitoring the emergence of such dynamics (See What the markets are trying to tell us). The fuel was the excessive disconnect between financial prices and fundamentals. The proximate market spark was concern that the underlying wedge -- that is investors' excessive faith in the power and effectiveness of central banks -- was being undermined by signs of policy inconsistency and less-than-stellar economic data (See A lot is riding on U.S. jobs data).
The liquidity dislocations initially hit the most levered and less-liquid markets (e.g., emerging markets, including local and corporate debt, and high-yield bonds). They were visible in wider and volatile bid-offer spreads, diminished willingness on the part of dealers to make markets, and investor concerns that exiting the market was no longer as viable an option as previously thought.
The resulting turmoil, including price gapping up and (more often) down, triggered reactions that gradually transmitted the dislocations throughout global markets. The cascade has been at first, gradual and sequential, but there is a risk that it could become disorderly and indiscriminate.
It is no longer just about emerging markets and high-yield, nor is it contained to the currency markets where the Yen has been particularly unstable. The phenomenon is now evident in investment grade bonds and inflation linkers. It is just a matter of time before it hits hard European government bonds, particularly the weaker economies. Absent a circuit breaker, it could well spread to U.S. and European equities.
The vast majority of asset allocation approaches are challenged in such circumstances, especially as traditional correlation matrices suddenly break down. Volatility and VAR-related trading strategies are hit particularly hard, forced to reduce leverage into liquidity-strained markets. Outflows from mutual funds and other accounts accentuate the disruptions, as do crossover investors who had ventured deep into off-benchmark asset classes and are now scrambling to get closer to benchmarks.
Yet there is a notable upside that accompanies the general sense of anxiety and havoc. As some prices overshoot in the downward direction, as they inevitably do, investors will come across opportunities that they previously could only hope for.
The key is to identify those anchored by solid fundamentals, even if the anchor is obfuscated for now by nasty market technical. And it is essential to size and time these trades appropriately as further volatility could well materialize.
Already we are witnessing the emergence of value again in certain segments of the emerging markets (e.g., local bonds in the highest quality emerging countries and, external credit -- sovereign, quasi sovereign, and some corporates -- in economies with massive reserve cushions and virtually no debt), parts of the yield curve in government bond markets in advanced economies (including the intermediate part of yield curves), and certain short dated volatility trades.
Successfully navigating today's volatile market environment and effectively seizing market opportunities requires a combination of careful risk management, an analytical framework that separates signals from noise and, yes, intelligent courage.
Investors combining resilience and agility should expect an expanding set of overshoot-related opportunities to emerge in the period ahead, especially as the current market instability may well need some time to reach the point of natural exhaustion or liquidity interventions.
Mohamed A. El-Erian is the CEO and co-chief investment officer of PIMCO.