Mohamed El-Erian warns that stocks could tank if the Fed’s liquidity ‘engine’ stops running, cites disconnect between prices and fundamentals

• Economist Mohamed El-Erian says markets may falter as the Fed’s liquidity “engine” becomes less and less powerful, and as investors begin to challenge elevated valuations. 
• “If that engine disappears, we have a long way between where asset prices are right now and where fundamentals will validate them,” he told Bloomberg TV. 
• In a separate op-ed for Bloomberg, El-Erian said economic and corporate fundamentals must improve for valuations to be sustained.
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Renowned economist Mohamed El-Erian says the stock market faces downside risk as the Fed’s liquidity “engine” becomes less and less powerful. He also sees the possibility of a dip if more investors start to question whether sky-high valuations can be validated by fundamentals.

“Where we go from here is going to continue to be liquidity driven, if that engine disappears, we have a long way between where asset prices are right now and where fundamentals will validate them,” he said in an interview with Bloomberg TV on Friday.

El-Erian detailed how, since Wednesday’s FOMC meeting, there have been signs that investors are “less comfortable about the effectiveness of Fed liquidity,” and as a result of that, “more willing to challenge pretty elevated valuations.” 

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In a separate Bloomberg op-ed published before the interview, El-Erian warned that the Fed has injected liquidity into markets not only through policies, but by sparking a fear-of-missing-out mindset for investors. 

“The Fed’s repeated support for financial markets has engendered a deep ‘buy-the-dip’ investor conditioning and a prominent FOMO mindset,” he wrote.

Now that the Fed isn’t meeting for the next two months, El-Erian expects “more skeptical investors may now feel more comfortable to challenge valuations.”

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For these valuations to be sustained, more economic improvement and stronger corporate fundamentals are necessary, wrote El-Erian.

Citing Thursday’s mildly improving jobless claims, he said: “The economic recovery continues but at a space that is too slow relative both to what’s possible and what’s needed.”

“Unless Congress steps up to the responsibility of taking timely action to support both the demand and supply side of the economy…the risk increases of a missed market hand-off from previously strong but fading liquidity to what’s urgently needed also for economic and social well-being: A strong lasting and inclusive recovery,” El-Erian wrote. 

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