Five lessons to take from last week’s wild markets

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It might be tempting to conclude that there are no lessons to draw from the wild ride in financial markets last week. After all, the Standard & Poor's 500 Index closed 1 per cent higher Friday, and the Dow Jones Industrial Average and the Nasdaq 100 Index ended up recording their best week in almost two months. And some might even dismiss the unusual volatility as the reflection of nothing more than a bout of market irrationality that is temporary, reversible and inconsequential.

Such an approach would be inappropriate, much like concluding that crossing minefields isn't dangerous just because we were able to do so once without harm.

Many indicators confirm that last week was remarkable and historic. Record after record was set, including the largest daily move, the biggest intraday reversal and the most harrowing intraday air pocket.

In all, the Dow travelled an unprecedented 10,000 points in just five trading sessions. The VIX, often referred to as the markets' fear index, spiked to levels not seen since the worst of the 2008 global financial crisis. And, outside the United States, emerging-market currencies crashed below the levels reached in the darkest days of that crisis.

Destinations often matter more than journeys, so there is a natural inclination to believe that last week's extreme volatility doesn't have much predictive value. That would be a mistake, for at least five reasons:

First, it now should be clear the fundamental underpinnings of the financial markets are – at a minimum – somewhat fragile. As a result, there are legitimate questions about the robustness of the global economy, potentially creating uncertainty for market prices that already have been notably decoupled from fundamentals by central bank policies.

Second, many retail investors seem unable to stomach such bouts of volatility, resulting in outsize disposals of equity mutual funds (with the majority of the sales seemingly taking place during the worst of the market overshoot and contagion).

Third, the plumbing of the marketplace appears far from immune to dysfunction during periods of great price volatility. The manifestations include elusive liquidity or trading systems that get overwhelmed when too many investors rush for the exit at the same time. The impact is amplified by the popularity of exchange-traded funds, some of which struggled to function as promised when subjected to market discontinuities and circuit breakers.

Fourth, during intense volatility, the good gets washed out with the bad. This is particularly true of widely held investment brands – such as Apple Inc., General Electric Co. and Google Inc. – that investors turn into ATMs when they are rushing to raise cash, whether as a precaution, for speculative reasons or to meet sudden obligations. When overleveraged and unhinged investors need to sell, careful selection of marquee-name assets and diversified portfolio allocations become much less of a shield.

Finally, though policy-makers are still eager to curtail spikes in market volatility, they already have expended a lot of ammunition via quantitative easing, floored interest rates and other unconventional policies. As a result, the series of monetary policy actions in China and the calming remarks from New York Fed president Bill Dudley last week could soon be tested by developments on the ground.

Given that more roller coaster rides could be in store, investors would be well advised to immediately assess two things: whether they can stomach this kind of volatility again without being forced to sell at the worst possible time, and whether they have enough reserve investing firepower to pick up the bargains that inevitably emerge during these episodes of market craziness.

Mohamed El-Erian is the chief economic adviser at Allianz SE. He's chairman of Barack Obama's Global Development Council, the author of best-seller When Markets Collide, and the former chief executive officer and co-chief investment officer of Pimco.