We have seen another example of the ability of stocks to ‘whistle past the graveyard’ over the past month.  For all of the apocalyptic forecasts ahead of Brexit, the vote’s negative outcome proved to be a catalyst for higher asset prices and we didn’t get the sell-off all that many experts had predicted….again.  While stocks initially fell on the vote results, that weakness lasted only a few days as investors, once again, focused on the potentially positive reaction by global central bankers to any economic or financial market risks.  The brief sell-off after the vote gave governments and central banks an excuse to ’prime pump’ their economies, in an attempt to stretch the global cycle for a little longer.  Japan’s Shinzo Abe kicked off the first round with a huge fiscal package, ostensibly worth $270 billion (or 5.6% of GDP) to boost their moribund growth.  South Korea then jumped in with $17 billion of measures themselves.  Britain is probably not far behind as they prepare their first post-austerity Budget this autumn, while France’s Francois Hollande and Italy’s Matteo Renzi have seized on Brexit and plan to run larger deficits themselves.  Brexit has allowed the world’s governments to turn the page on the austerity era and once again ramp up the spending.  The Bank of Japan’s balance sheet has reached 92% of GDP.  It owns 38% of the Japanese government bond market, rising to 60% by 2019.  The increased liquidity is beginning to show up in the global money supply figures, which by some measures is rising at a rate of 10.5%, the fastest since the post-Lehman stimulus.  The figure for China is even more explosive at 45% (six-months annualized).  This increase in money supply will eventually have its desired effect and ignite inflation….. maybe that’s what the gold market is trying to tell us with its rise this year!

In the U.S., a variety of stimulus packages over the years also have failed to achieve exceptional results.  The 2009 spending package of $830 billion, seven years of near-zero interest rates and about $3.7 trillion in money-printing — called quantitative easing — resulted in an economy that has yet to register a calendar-year gain above 3 percent since the financial crisis.  The Fed now finds itself with a credibility problem in which investors not only doubt its ability to goose the economy; as well as doubts about whether the central bank will be able to act should an unexpected crisis hit.

But why worry?  The central banks have our backs covered!  That seems to be the over-riding opinion of most investors.  Despite the risks associated with the aftermath of Brexit, significant non-performing loans and capital deficiencies in European (esp. Italian) banks, an upcoming US election, a recent increase in terrorist events and an attempted coup in Turkey, the measures of market sentiment have been remarkably calm.  The VIX, the market’s “fear index” has seen fewer spikes and remains close to multi-year lows.  Investors have been conditioned by years in which “buy on dips” approaches have repeatedly proven profitable, especially in markets recently achieving new highs.  This has brought U.S. stock indices back to record levels despite the fact that over 30% of global government debt, $11.5 trillion, now carries negative interest rates. There are trillions more with yields barely in positive territory or running well below historical averages.  The situation with low-yielding debt has gotten so extreme that Fitch Ratings warned that a simple normalization of yields to 2011 levels could cause investor losses of $3.8 trillion.  Those losses would come in the form of principal plunges, as prices fall when rates rise.  The low-yielding debt is held almost exclusively by institutional investors, meaning it poses systemic risks.  Logic appears to have taken a summer vacation as well!

While we did buy energy stocks back in February when oil prices were below US$30 per barrel and most of the sector looked like it was heading for bankruptcy, we did take profits a few months later after the stocks rallied.  But despite the fact that crude oil has now pulled back more than 20% from its June high, the stocks have not seen a similar setback.  The result is that the valuations of stocks in the energy sector have rocketed up to all-time highs.  The chart below shows the Price-to-Earnings ratio for the energy sector.  While this is only one measure, it has risen sharply since the beginning of the year, making the energy sector one of the most expensive sectors in the market.Energy stocks anticipating crude recovery

While the major risks in the sector have clearly been reduced due to the fact that prices have bounced off unsustainably low levels of early February and many of the highest-risk companies have raised enough capital in the past few months to keep them operating.  But investors putting money into this sector right now are betting that oil prices are going back up to the US$55-65 level over the next year.   That’s a long way from the US$40 level we are seeing today!

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