Investing legend Mohamed El-Erian says the US stock market is 'out of whack' for 2 reasons

There are two things seriously wrong in the US stock market, Mohamed El-Erian is warning.

The legendary economist and famed investor sounded another alarm about the state of markets recently. He pointed to two things in particular that worry him — valuations and technical signals in US stocks, which both look "out of whack," he said, speaking to Yahoo! Finance last week.

The AI trade has been volatile recently as investors rotate out of high-flying chip and memory stocks into areas of the market that have lagged tech's stellar gains. The Roundhill Magnificent Seven ETF, a fund that tracks the top seven tech giants at the heart of the AI trade, is down over 10% in the last month.

Valuations in the tech sector are stretched, even as the AI trade has cooled slightly.

The Shiller CAPE ratio — one valuation measure that reflects the market's cyclically-adjusted price-to-earnings ratio — is hovering near an all-time high.

High valuations are also evident in the tech sector's outperformance so far this year as well. Tech stocks in the S&P 500 are up 15% for the year, outstripping the 8% gain in the broader index.

Technicals. The market is also flashing some worrying technical signal, El-Erian said.

In a recent note, Bank of America said there are numerous signs the S&P 500 is overstretched, such as the index recently diverging from momentum signals and flashing a technical "exhaustion signal" in June.

"When valuations got out of whack, technicals got out of whack, and that's what we're seeing today. It's technicals that are undermining the tech trade," El-Erian said, pointing to selling pressure in the sector.

El-Erian also laid out two risk scenarios for markets that he sees brewing.

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One is that the market could see a near-term "air pocket" as the focus among investors shifts from building out AI infrastructure to actually monetizing AI, he said.

Another is the market reaction further out in the future as investors realize they overinvested in AI, he added.

"The longer-term issue is every single innovation ends up overdoing it in the first phase," El-Erian said, pointing to past booms and busts during the 19th century's railroad mania and the fiber optic boom during the dot-com bubble. "So yes, are there going to be some data centers that are going to not monetize investments? Yes there are."

El-Erian said the craze for artificial intelligence looks to be a market bubble, though it's a "rational bubble" in the sense that winning companies in the AI boom will eventually make up for the losses that are also inevitable in the sector.

Despite potential losses for investors, it's better for the US's economic future to over-invest rather than underinvest in AI, he said.

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