Investors are too complacent over the idea that financial markets will quickly rebound from any corrections caused by global turmoil, says Mohamed El-Erian, chief economic adviser at Allianz.
A big part of the problem is that market liquidity has shrunk, he tells
CNBC. Stricter regulations and fear of risk have led banks and brokerage firms to cut down on their trading.
"There's been a structural change," El-Erian proclaims.
"The broker-dealers have gotten smaller and will continue to get smaller. The end users have gotten bigger. So when the end users decide to reposition, and they all have to go through the middle, they find out that the middle isn't as robust."
That means "a selloff, and then it means dysfunctional markets," El-Erian argues. "The biggest risk out there is there's an illusion of liquidity. People actually believe that they can rationally bubble ride until the turn. When the turn comes, they actually believe they're going to reposition themselves. History tells us that there isn't as much liquidity as people think there is."
If investors lose faith that the U.S. economy is improving, stocks could fall at least 10 percent, he predicts.
"What we have is a structural change in the capacity of the market to provide liquidity. And if it's tested, then you get not only price corrections, but you get market stress."
New York Post columnist John Crudele says the drop could be double that. "Just how big is the bubble the market now finds itself in?" he asks rhetorically. "The S&P 500 is probably 20 percent higher than it should be based on fundamentals — like the fundamental of corporate profits."
The 391 S&P 500 companies that have reported fourth-quarter earnings so far registered blended profit growth of only 3.1 percent,
FactSet reports.
Crudele's math: at Friday’s close of 2,096.99, the S&P 500 was trading at a forward price-earnings ratio of 17.3. But the historical average is only 13.8.
That implies a 20 percent drop for the S&P 500 to return to the average. And that would put the index at 1,678.