Tuesday, February 26, 2013

Mergers and market tops

A prominent feature of the stock market recovery since 2009 has been the declining trading volume trend.  NYSE trading volume has visibly diminished over the last four years after reaching a climax in March 2009 (see below chart). 

To many savvy investors this is a negative sign which forebodes disaster.  A declining volume trend suggests a lack of broad-based participation; and while it’s true that this is detrimental to the market’s long-term health, the dynamics of today’s market have changed from that of yesteryear.  A market can rally on declining volume for weeks, months or even year at a time without seriously jeopardizing the market’s forward momentum.  What’s the reason for this anomaly?

The reason for this can be found in an understanding of liquidity.  When the Federal Reserve unleashed its easy money policy four years ago, it opened the floodgates of liquidity which allowed the equity market to bounce back from the credit crisis.  Some of this money was channeled into the financial market via institutional trading, but much of it was used by corporations for stock buybacks, dividends and, more recently, corporate mergers and acquisitions.  This explains how the bull market to date has been a volume affair: cash-rich companies have been the driving force behind it, taking the place of broad participation among individual investors. 

As Randall Forsyth observed in the latest Barron’s, “It’s more likely that the oceans of liquidity loosed by the world’s central banks and sitting idly on corporate balance sheets spurred the burst of deal-making…”  Examples include the $23 billion acquisition of H.J. Heinz by Berkshire Hathaway and Brazilian firm 3G Capital, Comcast’s $16.7 billion purchase of the 49% of NBC Universal from General Electric it didn’t previous own, Dell’s $24 billion proposed leveraged buyout, the $11 billion merger between bankrupt AMR and US Airways Group, and the $16 billion merger of Liberty Global and Virgin Media. 

“All told,” writes Forsyth, “some $160 billion of M&A deals have been announced so far in 2013, the fastest start to a year since 2005, according to Dealogic data cited by the Wall Street Journal. 

But doesn't the increasing wave of mergers harbinger a major top?  Historically, feverish merger activity does tend to coincide with major equity market peaks and this time should prove no different.  The devil is in the details, however.  In other words, timing is by no means an easy affair if M&A activity is your sole guide.  

A more practical solution is to incorporate technical analysis along with market psychology and other reliable guideposts for the timing of the market’s inevitable top and use the M&A boom as merely anecdotal evidence that we’re getting close to one.  Just be sure and leave plenty of leeway for the “whipsaws” that are sure to come between now and the time of the final “hard down” phase of the deflationary long-term cycle.

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