(Bloomberg Opinion) — A wild week for U.S. stock market indexes was accompanied by some eye-popping moves in individual listings, several of which were apparently driven by retail investors and lacked easy explanations other than exuberance. Some will be inclined to ignore this behavior, noting that, if not warranted, its consequences will be isolated and containable. While not ignoring it, regulators will end up taking a lassiez-faire attitude toward it primarily because their power and tools only go so far. Others, like me, will spend time thinking not only about the potential consequences, be it market functioning or distributional factors, but also the causes and their wider implications.
By now, and as illustrated by the Bloomberg article cited above, there is quite a list of individual stocks to choose from to indicate investor exuberance that could easily spill over into reckless risk-taking and speculation. My top pick is Hertz, which is going through a particularly rough time. (I know the iconic company well as a longtime customer.)
It’s not hard to see why Hertz had to file for bankruptcy. With both travel and leisure activities derailed by the Covid-19 shock, its revenue declined suddenly and precipitously. With a cost structure that is inherently inflexible — for example, it’s not easy to get rid of the stock of cars in a deep recession or sublet airport locations to another rental company — and with it’s notably uncertain outlook curtailing the prospects for normal bank and capital market financing, Hertz opted for reorganization through the bankruptcy process.
Being at the bottom of the capital structure, Hertz’s shares behaved as expected — at least initially. They traded in a relatively narrow range below $1, bottoming at around 50 cents after having started the year at $15.75. Then came astonishing moves and roller-coaster volatility.
The macro context was the retail-driven surge in equity markets fueled by what economists call adaptive expectations on the back of a historic rally, and what market participants refer to as “fear of missing out” and “there is no alternative.” The more micro context was a series of “rotation trades” — from “stay home” stocks to “reopening” ones, and from leaders to laggards. The result was a 10-fold jump in Hertz, together with several rather puzzling price moves in other less known companies.
Thursday’s sharp move in U.S. stocks, including single-day drops of 5% to 7% for the three main indexes, resulted in Hertz giving back almost two-thirds of its sudden surge. Then came the news that, equally surprised by the move in its shares, the company was asking its bankruptcy judge for permission to issue some $1 billion in new equity. Rather than react negatively to this new risk of dilution, the stock price rose 37% on Friday, buoyed by indication that a significant number of buyers would ignore the company’s warning of a potentially worthless stock and look to place orders.
Some will be quick to dismiss this sort of wild stock market behavior based on one or more of the following arguments: Investors are free to do what they wish as long as the risks they are taking are made explicit both by the companies they are buying and the intermediaries involved; and the wisdom of crowds is likely to know better than any one individual.
Although regulators will be paying attention, they will feel forced to stand on the sideline because they cannot easily impact the underlying behavior. Their macro-prudential policy measures are not focused enough, even if they were willing to deploy them, and most of the more refined tools are equally challenged when it comes to excessive risk-taking by nonbanks. They may also be worried about being blamed for a disorderly premature burst of a market-dominant narrative that could then spill over to an already fragile real economy. Finally, and as noted just last Wednesday by Federal Reserve Chair Jerome Powell, the central bank is not comfortable making judgments about financial bubbles, let alone seeking to deflate them — this as the vast majority of market participants and observers believe that the Fed’s repeated and, many feel, now highly predictable huge injections of liquidity have boosted asset prices, both directly and indirectly.
One result of all these interactions is the turbocharging of what, at the macro level, has been a notable disconnect of finance from the real economy. It places a big question market on the important role that capital markets play in mobilizing and allocating capital efficiently and in sending price signals that impact broader resource allocation within the economy. It highlights the extent of capital impairment risk being taken in particular by the retail investor, whose healthy engagement is important not only to market functioning but also to broader buy-in by society for a market-based economic system. And it illustrates how years of exceptional central bank support for asset prices has led to an ever-expanding set of unintended consequences and collateral damage.
The big hope is that a broad-based, quick and durable increase in economic activity will better validate what, by many measures, is now markets’ blatantly excessive front-running of the economic realities and prospects. There is no way to know how long this hope will persist. But what should not be in doubt is the consequences of disappointment, especially as new health data cast more of a cloud over the notion of rapid full economic reopenings around the world: a shock to equity markets that would undermine not only their standing but also inadvertently contribute to lower economic growth, greater inequality, household economic insecurity and the credibility and effectiveness of important policy-making institutions.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He is president-elect of Queens’ College, Cambridge, senior adviser at Gramercy and professor of practice at Wharton. His books include “The Only Game in Town” and “When Markets Collide.”
©2020 Bloomberg L.P.
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