PIMCO's CEO: Stay on the Sidelines Now

Red continues to pollute the ticker tape these days. This time we can blame BP (NYSE: BP  ) and Europe.

What's an investor to do? Mohamed El-Erian, CEO and co-chief investment officer of Pacific Investment Management Company (PIMCO), the world's largest bond fund manager with just over $1 trillion under management as of March 31, says stay on the sidelines until we learn more about the European situation.

When I last spoke with El-Erian in late December, he predicted the first quarter would look fine, but that afterward the economy and the markets would turn bumpy, with a high probability that stocks would move lower this year. He also said that emerging economies such as Brazil, India, and China would recover strongly, while the developed world -- the U.S., U.K., and the rest of Europe -- would grapple with debt problems. So far his thesis has proved spot on. Here are his thoughts now.

Jennifer Schonberger: We're officially in a correction now in stocks. Where do we go from here? Do we have further to fall?

Mohamed El-Erian: I think that we are still pricing in too much of a "V," and we're not pricing in enough of the structural issues. At this point, the best thing to do is to stay on the sidelines. There will be lots of opportunities to pick up value, but one has to wait for greater clarity as to what's happening in Europe. Put another way, the list of known unknowns at this point is quite long. We think equity investors should retain some optionality.

Schonberger: What about bond investors? Do you think there's an opportunity there, or again, would you stay on the sidelines?

El-Erian: I would say use high-quality government bonds to get some income, and to be your venue for location, liquidity, and safety.

Schonberger: Would you buy gold at these levels?

El-Erian: It depends on what else you have in your portfolio. I can tell you that we had an allocation of gold in our multi-asset products, and we've halved it recently. We still think it makes some sense to have an allocation to gold, but not as much as we used to.

Schonberger: So, if you have no exposure right now, would you steer clear of investing in gold?

El-Erian: I would wait and see how the deleveraging process plays out. I think that if the world de-levers further, which is not immaterial, then gold will be hit.

Schonberger: Will risk associated with investing in general remain higher across asset classes than it has been historically? Have the risk and returns changed for investors, and if so, how should investors change their approach?

El-Erian: Yes. Three things have changed. One is where returns are generated, and that's part of the global rotation in growth and wealth dynamics. The second thing that has changed is the volatility of markets. We should tighten our seat belts, because in this bumpy journey to a new destination, markets will be more volatile. The third issue that has changed is correlations -- in particular, portfolio diversification. While it remains absolutely necessary, it will no longer give you the same amount of protection, or the same amount of risk mitigation that it did in the past. Investors have to get used to a world where the sources of returns are moving, the volatility of markets is going up, and correlations are changing.

Schonberger: Right. We're seeing a correlation now between commodities and stocks.

El-Erian: Correct. Also, U.S. domestic equities will be much more correlated to global equities than in the past.

Schonberger: Then that calls for a much more agile investor?

El-Erian: Yes. It calls for a few things. First, it calls for forward-looking asset allocations. Secondly, it calls for revisiting benchmarks, because benchmarks tend to capture the world of yesterday, not the world of tomorrow. Third, it calls for complementing diversification with tail hedging. The value of that has been demonstrated dramatically over the last few weeks.

Schonberger: In 2008, the bond market was telling the real story. Should we be watching the currency markets for the real story right now?

El-Erian: I think in the short term we should be watching the inter-bank market. The highest information indicator for the global banking system is inter-bank activities -- whether banks trust each other or not. So, look at Libor, because if this crisis morphs into something even more sinister, it's going to be because the global banking system is under pressure.

For El-Erian's take on the European debt crisis, click here.

Fool contributor Jennifer Schonberger does not own shares of any of the companies mentioned in this article. You can follow her on Twitter. The Motley Fool has a disclosure policy.


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