With Mohamed El-Erian, Bloomberg View columnist, Chief Economic Advisor at Allianz, and Chairman of President Obama’s Global Development Council
Continuing with our new series called “The Great Investors, What’s in their Wallet?” The Steve Pomeranz Show has invited Mohamed El-Erian, truly one of the world’s greatest investors, to speak about his personal investing practices.
Mohamed is a Bloomberg View columnist, Chief Economic Advisor at Allianz, and Chairman of President Obama’s Global Development Council. In previous interviews, we discussed his latest book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, and he helped us understand and get some needed perspective on the implications of the Brexit referendum, when that was a big issue a few months ago.
A Peek Inside Mohamed’s “Wallet”
It may be surprising to learn that about 30% of Mohamed’s portfolio is in cash at the moment, which Mohamed acknowledges doesn’t pay him anything at all. He states, in fact, that inflation actually eats away the real purchasing power of that cash. So how does he explain his present position?
“We have been living through a very unusual period in which financial assets have been decoupled from fundamentals and for good reason. Central banks have tried to use the financial markets as a way of promoting growth, by pushing up artificially asset prices, making people feel richer, and triggering the wealth effect, so they’d go out and spend more. Unfortunately, it hasn’t worked.”
The Investor’s Defense
With central banks becoming less effective, the smart investor responds with resilience, in case prices do go down, and with agility to take advantage of overshoots. In that vein, Mohamed says he has reduced his holdings of public equities and public bonds and moved those mostly into cash, and, in addition, has invested more actively in venture capital.
Dealing With Artificially Low-Interest Rates
In spite of the fact that stock prices are high relative to other risky investments, stocks are still an attractive option, and the equity market, says Mohamed, “is the only place you can get any returns or expect to get any returns.” In order to keep the economy moving forward, the Fed has created artificially low-interest rates, which, in turn, has produced an over-priced market. At some point, prices will go down and having cash on hand enables an investor to buy at more attractive prices when that does occur.
The Illuminating Tale of the Dog and The Cat
To illustrate the concept of buying in an artificially priced market, Mohamed uses the example of the dog and the cat. There’s a cat that you can buy at $30,000, but there’s a dog that you can buy at $10,000. How would you choose? You might say, “I’d rather buy a dog at $10,000.” But, says Mohamed, “that doesn’t make it a good thing to do. It may be cheaper in relative terms, but in absolute terms it’s expensive.” And not a smart investment.
Choosing Your Mistakes as an Investor
Considering the many unknowns in the marketplace, it’s not possible to cover all bases when deciding where and how to invest, and the choice of either staying out of the market and waiting it out or going “all-in” is crucial. So which way do you go? Mohamed says “it’s better to recover from a mistake where you’ve left some money on the table than one in which you’ve lost quite a bit of money fast.”
Venturing into the Venture Side
With the stock market having done well this year, Mohamed has offset the 0% earnings on his cash by focusing on venture capital investments. Venture capital investments are early stage, risky investments in which you get an equity stake in the business with the hope that it will give back an excellent rate of return. Mohamed has chosen “areas that I think are subject to disruptions by this incredible revolution that’s happening in technology, artificial intelligence, big data, and mobility.” He cites Airbnb and Uber as examples of disruptive companies impervious to distorted valuations by central banks.
Understanding Tactical Investing
Tactical investing requires a certain strategy, says Mohamed, one that has no room for emotions but demands a strong belief and knowledge of the companies that you own: what they do, how they operate, and what initially drew you to them. You may have to steel yourself when—as often happens—your company falls prey to contagion, a market term meaning the good often gets pulled along with the bad. If crazy price movements happen, it’s not necessarily representative of what’s actually going on with that one business. If you keep your eye fixed on the balance sheet, falling prices could be an opportunity for a purchase.
Great Advice from a Great Investor
The most frequent mistake people make, says Mohamed, is getting sucked into buying when things are going up and then selling when the market begins going down.
Greater words of advice have never been spoken.
Steve Pomeranz: My guest is Mohamed El-Erian. He’s a Bloomberg View columnist and chief economic adviser at Allianz. He’s also the chairman of President Obama’s Global Development Council. In previous interviews, we’ve discussed his latest book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse. He’s helped us understand and get some needed perspective on the implications of the Brexit referendum when that was a big issue a few months ago. To hear these interviews again, simply go to our website, which is stevepomeranz.com, P-O-M-E-R-A-N-Z dot com, search for Mohamed, and you will find all of our interviews with Mohamed.
Now, for the subject today, I’ve recently begun a series called “The Great Investors, What’s in their Wallet?” which can also be found on the homepage of stevepomeranz.com. I’ve asked Mohamed to join me, as I consider him one of the world’s greatest investors. Mohamed, welcome back to the show.
Mohamed El-Erian: Thank you so much.
Steve Pomeranz: I’ve been reading about what you’ve been doing with your money and investors’ money. I was very shocked to see that you have a lot of cash in your portfolio. Explain why you have so much cash, how much, and so on.
Mohamed El-Erian: It’s not because I’m getting paid a lot to hold cash, but I’m being paid nothing at all…
Steve Pomeranz: That’s why it’s so surprising.
Mohamed El-Erian: …to hold cash. Inflation eats away the real purchasing power of your cash. This is not a positive decision. This is because of what else is out there. My concern, Steve, is that we have been living through a very unusual period in which financial assets have been decoupled from fundamentals and for good reason. Central banks have tried to use the financial markets as a way of promoting growth. In other words, push up artificially asset prices, make people feel richer, trigger the wealth effect so they’d go out and spend more. Unfortunately, it hasn’t worked.
My concern as an investor is the extent to which this decoupling has taken place. Now, it doesn’t mean it can’t go a little bit further. It can. I worry that we’ve come to a point where central banks are becoming less effective. The investment response to that is built-in resilience and built-in agility. Resilience to make sure that if prices do go down, you can still take the offensive and you’re not stuck just in defense, and agility to take advantage of what are likely to be overshoots. I have reduced my holding of public equities and public bonds. I have moved that mostly into cash. But in order to have some expected return, I’ve also been more active in the illiquid space, particularly in venture.
Steve Pomeranz: All right. We’re going to get to that in a minute. When I was researching for my interview with you, I took a look at what the PE multiple of the stock market is today. I was surprised. The Dow is at 20 times earnings. The S&P, according to the source I used, was at 24 times earnings. This wasn’t the Case–Shiller S&P. This was based on trailing 12-months earnings for the S&P. Now these S&P numbers, these PE numbers rather, bounce around a lot. I’m never sure which one to believe, but let’s just use those two as an example. I think it does reinforce what you’re saying. When the S&P is selling at 20 times earnings, if you flip that around and you say, “Well, I’m getting a dollars- worth of earnings and I’m paying $20 for that.” What is $1 as a percentage of $20? Well, it’s 5%. You can say that my earnings yield is 5%.
Then you say, “Well, if my earnings yield is 5%, how does that compare to other, let’s say, risk-free investments?” The 10-year bond is trading at about 1.8%, so I’m still getting more than that. Then you factor in, well, how much risk am I taking to get this spread between the risk-free investment and the risk investment? If I use the S&P 500’s price to earnings ratio of 24, then my earnings yield is only 4.2. That seems to be very expensive, very rich. Am I saying, in effect, giving some credence or some facts to your thesis?
Mohamed El-Erian: You are, and you’ve done it in a good way. I would also caution against using relative measures. The argument which I completely agree with is that look around where you can get any returns, and the only place you can get any returns or expect to get any returns is the equity market. Yes, the PEs may be high, and they are high as you just noted but is sure a lot better than anywhere else. That argument is also applied to high yield bonds and other risky investments.
The problem with that argument is that you are comparing it to artificially low-interest rates. While the relative case for owning risky assets—maybe they’re the absolute case, as you just mentioned—is a lot weaker, it’s ultimately the absolute case that matters. Investors have to remember that you are being paid to take risks. It’s an absolute concept. It’s not a relative concept.
I use a silly example, if I may, Steve, of coming to you and saying, “Look, there’s a cat that you can buy at $30,000, but there’s a dog that you can buy at $10,000. What would you rather do?” You would say, I will say, “I’d rather buy a dog in $10,000.” That doesn’t make it a good thing to do. It may be cheaper in relative terms but, in absolute terms, it’s expensive. That’s my concern.
Steve Pomeranz: Well, I understand that. Where should interest rates be? I mean, we have inflation which is just really barely above 1%, maybe one and a half, 2%. Interest rates should be based on that. It should be based on the possibility of higher inflation, of economic activity. It doesn’t seem like interest rates are so incredibly overpriced or under-yielding because of that action. Where should they be?
Mohamed El-Erian: Let me put it a different way. We have a GDP that in real terms is growing one and a half to 2%. We have an inflation rate that’s in the one and half to 2%. Historically, if you were to apply this in an equation and say historically what would have been my 10-year interest rates? It would be about three to four and a half percent, not the 1.8, 1.9 where we are today. Similarly, we would not have a European Central Bank and the Bank of Japan having negative interest rates. Think about that. Negative. Meaning that if you lend your money, you pay for the privilege of lending your money.
Steve Pomeranz: It’s insane.
Mohamed El-Erian: We know that’s counterintuitive.
Steve Pomeranz: Yes, it’s insane. It’s a bizarre world that I can’t even imagine. Though I have noticed that the yield on German bonds has risen above negative, so there is some positive change there. That’s really beside the point. Your thesis is that you’re keeping 30% in cash because you think markets are overpriced due to so much fed intervention to keep the economies going and strong in their attempt to get the economy moving again. You think that there will be a regression to the mean at some point. Prices will go down and you want to have the cash in order to buy at more attractive prices. Is that correct?
Mohamed El-Erian: Yeah, that’s absolutely correct. I encourage a second type of thinking that complements this. It’s something that people don’t like to do. If I end up making a mistake, which mistake can I recover from? Here, there are two mistakes with investors. One is to stay out of the market and see it go even higher. All right. The other mistake is to wake up – and this happened in January and February of this year so it’s not as if it hasn’t happened – wake up to a 9% loss that happens very quickly. When I look both at the positive argument that you cited and when I also looked at what mistake can you recover from, I think, at these valuations, Steve, it’s better to recover from a mistake where you’ve left some money on the table than one in which you’ve lost quite a bit of money quite fast.
Steve Pomeranz: You have to be able to withstand some pain here because if you’re 30% in cash this year, unless your venture capital investments are just doing unbelievably well, you’re trailing the market pretty considerably because stock market has done fairly well this year.
Mohamed El-Erian: First, the venture side has helped a lot. When we buy insurance for a car, we don’t buy insurance because we think we’re going to crash the car, but we recognize that we’re willing to give up some cash in order to buy significant downside protection. That’s the mindset right now is to recognize that markets are artificial, recognize—not by choice but by necessity—because other policymakers have been paralyzed by Congress. By necessity, central banks have had to do more and more experimental stuff. We are seeing lots of unthinkables and improbables becoming reality. That’s not noise. That’s a signal. My own reaction is when you see a world like that, that’s hard to explain, that’s hard to sustain, then taking some money off the table is a prudent thing to do.
Steve Pomeranz: Better safe than sorry, I suppose. Right?
Mohamed El-Erian: Correct.
Steve Pomeranz: We only have a little time left. Let’s talk about your venture capital. These are illiquid investments of businesses that you’re getting an equity stake in with the hope that this business will grow and give you a future, excellent rate of return. Can you give us a little bit more detail about the way that works?
Mohamed El-Erian: Sure. They are focused in areas that I think are subject to disruptions by this incredible revolution that’s happening in technology, artificial intelligence, big data, and mobility. It’s enabling individuals to do things that they’ve never been able to do before. It can change complete industries. We’ve seen this, of course, with Uber and the urban transportation. We’re seeing it with Airbnb. It’s happening in lots of different sectors. The idea is to try and identify these areas. Now, why are they attractive to me? Central banks cannot reach them. It’s much harder to distort the valuations in that space than it is to distort the valuations in public markets which is what has occurred.
Steve Pomeranz: You talk about overvaluation. A lot of these disrupters, you mentioned Uber and others, they’re already, I don’t know if you’d say they’re overvalued, but they’re extremely high price relative to what they’re currently doing and even based on future expectations of earnings. How do you deal with that fact that it’s already built-in to the price?
Mohamed El-Erian: This is not buying Uber once it has matured and gone through multiple rounds of financing and even IPOed. This is trying to get them at an earlier stage. I should caution. This is a true portfolio approach. I don’t know of anybody who has a batting average that’s over 500 in this area because, by its very nature, the payoff is very different from public markets. The payoff is if one, two, or three out of 10 turned out to be winners, you can more than afford the losses on the others. That’s the element. The other thing I would say to investors is don’t hesitate to be more tactical. We will see the markets become a lot more volatile as these fundamentals start to assert themselves on artificial valuation. We are likely to go through a roller coaster. We are likely to have a situation where tactical investing as opposed to long-term strategic investing belongs also in your portfolio. That’s, again, against conventional wisdom. Conventional wisdom says, “Buy it and hold it.” Ironically, had you done that for the last two and a half years, you would have earned nothing at all.
Steve Pomeranz: That’s right. Markets are bad.
Mohamed El-Erian: You would have gone through quite a roller coaster.
Steve Pomeranz: Well, it’s easy to say to be tactical, but to actually accomplish that in a successful way, I think, is really pretty difficult. Really, for the average person to try to be tactical is probably more dangerous or has a greater chance of a poor outcome than a positive outcome. How would you advise the average investor to be more tactical?
Mohamed El-Erian: First, I would say you’re right. That’s really the important caution to note. Don’t be tactical on the way up. Don’t get sucked in when everything else is going up. That’s the most frequent mistake people make. Then they compound that by selling when the markets have gone down a lot. Don’t be tactical in an emotional sense is the first thing. Then the second thing is have a handful of high-conviction names that you really believe in because what tends to happen when markets trade down is what the profession call contagion. Because of some very genuine and legitimate technical effects, the good gets thrown out with the bad for a while. Have a few a names that … these are your high-conviction investments. You understand them. Preferably, you are exposed to them in terms of the companies, what they do, and how they do it, and have them on your list. When things look pretty awful, go back and answer your question. Why did I like them to begin with? There’s a high chance that they may have been technically contaminated. It was fundamentally contaminated.
Steve Pomeranz: Don’t believe that the price movement is actually a representation of what’s going on necessarily with the business. It might be, but keep your eye on the business and the balance sheet of the business. Make sure you know what you own. Then once you do that and you see the price going down with everything else, that could really represent an opportunity for a purchase.
My guest Mohamed El-Erian, Bloomberg View columnist, chief economic adviser at Allianz and also the author of The Only Game in Town: Central Banks, Instability, Avoiding the Next Collapse. This has been one of our series of “The Great Investors, What’s in their Wallet?” I think we really found out what is in Mohamed’s wallet. To join the conversation, to hear this again, to read the transcript or see the summary of this, don’t forget to go to stevepomeranz.com. That’s P-O-M-E-R-A-N-Z, stevepomeranz.com. Mohamed El-Erian, thank you so much for joining us today.
Mohamed El-Erian: My great pleasure. Thank you so much, Steve.