In last week’s commentary we pointed out that the accumulation of debt by corporations may be behind the market upswing (through shares buyback programs while the fundamentals do not support such uptrend). The fact that yields on sovereign and corporate bonds have declined so much could be considered a signal of fear if the underlying cause is uncertainty about growth and  earnings. At the same time, we have witness a significant appreciation in precious metals so far this year (close to 30% for gold and silver).  This too could be perceived as another signal that uncertainty drives capital into safe havens.

However, if it is fear that drove investors to bonds and precious metals, how does one justify the not negligible returns of equities (at least in the US) so far this year? While we cannot deny the possibility that fear may have caused the bond and precious metals upswing, we offer the opinion in this commentary that there is a central bank and investor psyche dynamic that is unfolding and which may be shaping the next market cycle.

We believe that central banks are being perceived as the main game in town (not necessarily the only game in town). The famous Greenspan and Bernanke puts established the central banks as the big daddy who steps in and rescues declining markets. The QE programs around the globe send clear signals that the era of low interest rates is here to stay because it advances the interests of most players. The reality is that nations can no longer afford normal interest rates due to the abnormal debts they have accumulated. Could Japan with a debt-to-GDP ratio of over 240% afford a 4% interest rate on its bonds? Could any EU nation afford such an interest rate? Could the US afford to pay just for interest on its debt close to $800 billion per year?

Given that nations and corporations cannot afford to pay normal interest rates, investors then take it as a given that central banks will suppress (with QEs, OMTs, etc. ) interest rates for the foreseeable future and may even throw some money from helicopters in order to deflate the debt. In that environment the main market determinants in town (central banks) can tolerate to see their greatest foe (precious metals) to experience an upswing since the overall idea is to keep rates down, encourage risk taking, stimulate investment and spending, and see growth happening that would make debts more affordable.

However, the market also senses three additional forces at work: First that real hard assets (real estate, precious metals, vessels, etc.) may be cheap, so this is the time for accumulation; second, important developments (Brexit, significant market moves such as changes in oil prices, etc.) make sleepy markets to jump and thus leverage is used to grasp “opportunities”; and third, the options that central banks have are diminishing as the law of diminishing returns takes hold of markets.

Therefore, as investors seek returns they discover that stocks can yield significantly more than bonds. That potentially can become a sustaining force of an overvalued market which can keep driving it up higher even if historical norms are surpassed, especially when you perceive that central banks may be running out of tools but will be there to support a declining market. If that were to be the case, then we may be experiencing an era of equity cult. We only hope that this era will not become a widow maker force.