Pimco's El-Erian: Why Zombies Threaten Markets

The “zombification” of companies living on easy credit could hurt investors who are not prepared.

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• "Resist the short-term focus of those financial pundits who have abandoned fundamentals in favor of just obsessing with what is cheaper only in relative terms." Here, El-Erian gives his most specific advice, to avoid buying "risky sub-investment grade bonds" just because they are inexpensive.

• Try to avoid "falling hostage to outdated and backward-looking labels, benchmarks, guidelines and mindsets," he writes. That means avoid conventional wisdom. Or in Berra baseball terms, know that "The future ain't what it used to be."

• "Evolve risk management approaches," El-Erian writes. Portfolio managers increasingly have been taking new approaches to diversification. El-Erian gives no specifics. Diversification formulas of the past "continue to change in this fluid world heavily impacted by central banks," he writes. Some fund managers are putting their fixed-income allocations into more dividend stocks, whose payouts can increase if rates rise, while bonds are fixed.

[Read: 5 Lessons From the Last Stock Crash.]

• "Do not give up liquidity cheaply." This sums up El-Erian's cautious overview. Risky investments have been in vogue since the start of the year. But now, he writes, "look for continued, selective offense to accompany our increasingly defensive general positioning over time."

The dark cloud for the market is the "zombie" scenario in which companies don't invest as central banks remove their generous accommodation. That danger lurks, and El-Erian sees "an increasing number of sectors that have rehabilitated their balance sheets but have yet to collectively reach escape velocity." In the meantime, the post-crash stress syndrome still hovers over the land. Companies are hoarding cash, taking a short-term view and stumbling to find true north in the recovery on the path of slow, Fed-induced growth. Edwards says to watch the housing sector that was the epicenter of the 2008-2009 crash. More encouraging signs in housing would be an indicator of a more sustained recovery in the broader economy, he says.

The market is already at record highs, however, and it will take true earnings gains to carry it higher. Edwards is watching for a continuation of the housing recovery along with more lending from banks and more hiring. Time will tell, and in the meantime, as they say in the dugout, "You can observe a lot by watching."