Key Words: The pros are getting ready for a market crash — retail investors, not so much, top economist warns

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Mohamed El-Erian

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‘A large market correction, should one materialise, would encourage more professional selling that could overwhelm the buy-the-dip retail investor.’

That’s Mohamed El-Erian, Allianz’s chief economic adviser, explaining in an op-ed for the Financial Times how action in the options pits should be taken as a warning by retail investors who have been cashing in on the stock market’s relentless push higher in recent months.

“The seemingly endless rally… gives the impression that prices are endorsed and supported by the entire professional investment community,” he said. “After all, despite the vocal concerns over valuations having split away from underlying corporate and economic fundamentals, few fund managers have been willing to challenge the market by placing outright shorts. “

However, “sophisticated investors” are expressing their cautious views with the use of derivatives, and El-Erian says the mom-and-pop types should take note.

“It is hard to overstate the extent of today’s risk-taking in U.S. financial markets,” he wrote, pointing to the explosive moves in a small number of high-flyers, such as Apple AAPL, +2.29%, Tesla TSLA, -2.16% and Amazon AMZN, +1.16%.

“Much of this could be seen as market deepening were it not for one troubling fact: corporate and economic fundamentals have yet to reflect a sustained and convincing recovery from COVID-related damage,” he said. The rebound in consumption is slowing, initial jobless claims are back to the 1 million level for a second straight week, bankruptcies are rising, and, according to El-Erian, it’s looking like these short-term disruptions are about to become long-term scars.

“Rather than a well-thought-out bet on the future, stocks reflect many investors’ resolute faith in a consistently favourable and predictable liquidity environment,” he wrote. “It is a backdrop anchored by reliable stimulus from central banks.”

On the surface, the same can pretty much be said for what we’re seeing in the derivatives market, but there’s more to it than just that.

“The fear of missing out on an unceasing equity rally has increasingly been expressed through call options,” El-Erian said. “Those who would normally short the market on concerns of excessive valuations appear to have no desire to be steamrollered once again by favourable liquidity and the strong ‘buy-the-dip’ conditioning that comes with that.”

He pointed out that buying call options limits risk and gives traders the ability to take strategic shots at capturing rallies. At the same time, the smart money is hedging bets with downside “tail protection” to guard against the inevitable sharp declines. That’s why we’re seeing the VIX volatility gauge VIX, -1.51% decouple from equities, another sign, according to El-Erian, that retail investors are particularly vulnerable when the sellers take the upper hand.

“It would take a big shock for markets to move significantly lower — such as a renewed sharp economic downturn, a considerable monetary or fiscal policy mistake, or market defaults and liquidity accidents,” he wrote. “But should such a move occur, the likelihood of further market turmoil would be high, especially given the current lack of a short base to buffer the downturn. This exposes small retail investors to big potential losses.”

No sign of the dying of the bull Tuesday, with the Dow Jones Industrial Average DJIA, +0.15%, Nasdaq Composite COMP, +0.86% and S&P 500 SPX, +0.25% moving higher.