Ultimately, it comes down to Dodd-Frank.
When historians write about the manic 2013, the year of rampant speculation, they will always refer to these two wise men, who put their heads together and came up with a plan to curb speculation in the financial markets. Without Dodd-Frank, historians would write, 2013 might not have seen the mother of all speculative bubbles after all.
But then, I get ahead of myself. This is what happens when I get excited about something. We should first start with QEternity. That's what got the ball rolling.
For those that are wondering what QEternity is all about, the Fed is buying $85B in mortgage backed securities ($40B) and longer dated US Treasuries ($45B) every month from here to eternity, or the time when US unemployment falls below 6.5% and inflation is less than 2.5%, whichever comes first.
What does this mean for equities? Well, for starters, let's figure out what it means for bonds. There is a crucial shortage of Treasuries as a result. Reports Bloomberg:
Treasuries and other dollar fixed- income securities will be in short supply next year as the Federal Reserve soaks up almost all the net new bonds.
The government will reduce net sales by $250 billion from the $1.2 trillion of bills, notes and bonds issued in fiscal 2012 ended Sept. 30, a survey of 18 primary dealers found. At the same time, the Fed, in its efforts to boost growth, will add about $45 billion of Treasuries a month to the $40 billion in mortgage debt it's purchasing, effectively absorbing about 90 percent of net new dollar-denominated fixed-income assets, according to JPMorgan Chase & Co.
One obvious conclusion to draw from this is shortage of anything drives up prices, so this will drive Treasuries up, and in turn lower yields (as bond prices move in the inverse direction as yields). So, the yield curve will keep getting flatter and flatter. Since the long yields are tied to so many important borrowing rates, the consumers will get access to lower borrowing rates, which in turn is good for the economy.
But that's just looking at things superficially. In the absence of Dodd-Frank, it probably would be an adequate analysis. But enter Dodd-Frank, and that changes everything. Again. Just like the iPhone4. (I wonder how they do that!)
You see, Dodd-Frank aims to curb the appetites of risk takers and speculators. When speculators place their punts, Dodd-Frank requires them to post collateral, good-quality collateral. Reports Businessweek:
To improve the safety of the financial system, the Dodd-Frank reform law requires that most derivative deals be executed on a clearinghouse that will require traders to post collateral and will provide a central place for regulators to keep an eye on risk in the market.
This means no longer can a speculator post an IOU from his dog as collateral when making, say a few billions dollars in punt that the Italians will default on their sovereign debt. They need to put in good quality collateral, something like, say, the Treasuries, as coverage in case their punts blow up and they can't pay back the counterparty. Trouble is, Treasuries are scarce these days.
So where would all the good speculators go? Home, perhaps, is the destination Messrs. Frank and Dodd had in mind, but that's not going to happen. So there is a mad dash to acquire Treasuries resulting in the acute shortage mentioned above. Now, when one group of high grade bonds become scarce, the other high grade bonds automatically get high demand, as the investors in the first group get displaced from the former to the latter. In turn, the demand for high grade corporate bonds go up, which means corporate yields drop, which means corporations can take a bunch of loans at super low interest rates. Witness, for example, Intel Corporation (INTC) issuing some $5B in non-converts (first since 1997) for super low interest rates. This trend is common across the board. Reports Bloomberg:
Yields on investment-grade debt fell to 3.74 percent from 4.1 percent at the start of the year, Bank of America Merrill Lynch index data.
Now we are cooking with gas. Companies can now borrow at rates that even the US Govt didn't get a few years back. So they can raise tonnes and tonnes of money for peanuts. Question is, what will they do with the money?
Traditionally, companies will issue debt when they need money to grow the business. But American companies have been sitting on record amounts of cash for a while and not investing. What gives us the comfort that they will actually do something productive with this borrowed money when they are not doing that with their own money in the first place? I have a gut feeling that companies will follow the lead of Intel here and start doing stock buybacks. This will especially be true for big companies with stellar credit ratings who can borrow at very low interest rates and have the cash flow to pay back the bonds without a problem, but are not growing. As they are not growing, their stock prices are stagnating. They will try to boost share prices by buying back shares.
So far, so good. Companies get almost free money to speculate on their own shares. The shares go up, and everyone is happy. Trouble is, real life is complicated, and share buybacks do not boost share prices for a variety of reasons, mostly due to arithmetic. For those unwilling to take this at face value, you may want to read my dual posts here, and here. I will not repeat the rationale here as it is not important to my thesis.
One thing, however, share buybacks do without fail. They lower the number of shares. These companies with high credit ratings also typically have some kind of a dividend associated with them. As their float drops, so does the pool of dividend paying stocks that investors can chase.
This leads to a problem. Imagine you are a fixed income investor. You cannot get enough Treasuries, and anyway Treasury yields are super low. You can't get enough corporate bonds either, and yields there are super low as well. So you have no choice but to go for dividend yielding equities, and the float for those equities is dropping as well. So what do you do?
You buy like dividend yielding equities are going out of style. You buy it with your milk money. You stand in line for hours to get your share, as if dividend yielding equities are like the launch of iPhone 5 in China.
OK, poor analogy, but you get the point.
So, now, if you are a speculator, what should you do? You try to front run the crowd, of course. You buy shares of these companies with very little growth but with dividends as soon as possible, and wait for them to declare share buybacks. The stocks soar, you dump the shares, and move on to the next target. Pretty soon any and every company is issuing bonds to buy back stocks to get a temporary boost in share prices. This, of course is the ideal ground for speculation, something that Dodd-Frank set out to control.
Alas, but life works in mysterious ways.
When there is speculation, there is the market making new highs. We all have been through the glorious days of the 1990s. So, I think that 2013 will be a banner year for equities in the United States, especially for dividend yielding ones. To see my personal punts this year, read my previous article. This post was not supposed to be about individual equities or ETFs. This was supposed to be about a broad trend, a theme for 2013. But one obligatory ETF recommendation is the PowerShares S&P 500 High Dividend Portfolio ETF (SPHD). Look it up.
Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice.