El-Erian: Why Good Companies May Get Even Cheaper for Awhile
Should investors buy good companies trading at historically attractive prices? This simple question is rightly on the mind of many investors as they survey the damage inflicted by the third quarter's sharp and generalized collapse in global equity markets.
It has already enticed some to buy at prices that, as Warren Buffett observed this weekfor his company, appear below "intrinsic value."
According to conventional wisdom, this simple question has an equally simple answer - "of course" - that is supported by the vast majority of historical cases. And it is an answer that would seem particularly appropriate today given that so many multinationals are still in great financial shape, pay relatively high dividends and trade at compelling historical valuations.
But before acting on conventional wisdom, investors should ask themselves why so many unthinkables have turned into reality over the last few months. By doing so, they would be forced to consider important qualifiers arising from historic structural changes buffeting the global economy and, therefore, financial markets.
Cheap stocks and corporate bonds can get a lot cheaper before regaining their footing. This is especially true when the combination of too much debt and too little income growth forces a system to delever, as is increasingly the case these days.
In such a world, markets are driven by top-down economic and policy factors ("macro") rather than company earnings and balance sheets. It is also a world in which "bad technical" can result in price behavior that deviates significantly from "fundamentals," and for a long time.
The dilemma confronting investors is essentially the same as that facing a home buyer looking at a good house in a rapidly-deteriorating neighborhood. It makes sense to buy if, and only if, the neighborhood is likely to stabilize, the buyer has the ability to hold on to the property, and he/she secures a sufficient price discount on account of the inherent uncertainty.
Investors with "permanent capital," like Mr. Buffett, are particularly well placed to strike this volatile balance. Yet they should only do so if they also believe that the combination of a bad macro and bad technicals will not, in itself, cause company fundamentals to deteriorate substantially and, thus, lower intrinsic values.
Economists have a term for this. They call it "multiple equilbria." It is a dangerous path-dependent phenomenon where one bad situation materially increases the risk of a subsequent situation that is even worse. It is the basic reason why so many well-run companies prefer to accumulate cash that earns virtually no interest income rather than invest and hire.
These dynamics are particularly worrisome today as market after market falls victim to volatile and destabilizing feedback loops fueled by weak economic growth, high unemployment, debt overhangs, fragile banks and inept policymaking. It is most evident in Europe where just the prospect of firesales can, and has totally destabilized intrinsic values. It also threatens the US where too many politicians and policymakers remain asleep at the wheel.
Have no doubt, there will be lots of opportunities down the road to buy good companies at cheap prices. If you do so today, you are betting that markets can escape decisively the grips of both bad macro and bad technicals. This is not a call on companies. It is about policymaking in Athens, Berlin, Frankfurt, Rome, and Washington DC.
Mohamed A. El-Erian is CEO and co-CIO of PIMCO, and author of "When Markets Collide".