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"You should expect the unexpected in this business; expect the extreme" Richard Dennis

July 28, 2014

Greased wheels

Something struck me from Michael Mauboussin's book More Than You Know.  He suggests that when M&A activity picks up in a big way, the acquirers are usually struggling to achieve returns much higher than the cost of capital.

This makes sense as managers get greedy watching their stock's price rise.  Naturally they want that to continue as their internal growth strategies mature.

Case in point 3D Systems.  They acquire a new business seemingly every month just so they can move numbers around and make their results look better.

As you probably know, Jeremy Grantham's GMO has a new quarterly letter out.  He's expecting the next two years to be a golden age in M&A with low rates and a 'young economy'.

"Don’t tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. There are massive reserves of labor in the official unemployment plus room for perhaps a 2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this recovery, and I use the word "uniquely" in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before. The very disappointment in the rate of recovery thus becomes a virtue for deal making. "

I've got a handful of thoughts on this.  Lets start with margins.

If margins are strong, rates of return likely aren't falling closer towards internal rates of return unless growth is maxed out and slowing.  Following that logic, there wouldn't be a massive M&A boost until we're at the end of the economic cycle.  Since there is this large amount of 'slack' in the economy, wouldn't that mean we're quite far away from that point??

Of course for ages we've heard that cash piling up on corporate balance sheets + low rates are reasons to acquire.  Well, what's new?  Possibly increased confidence and or greed due to a rising stock market.  Unfortunately, the real world has to deal with this mess of a political/economic/tax climate?  These issues are on the W.S. backburner right now, but they are as bleak as ever.

Consider me a skeptic.  Massive psychology shifts take years and years to unfold and right now there is no urgent incentive to take advantage of low rates.  We're living in a ZIRP world.  That incentive probably won't initiate until we see a pretty significant spike in rates.

While Mr Grantham may be correct about this boom, his argument doesn't exactly add up for a M&A golden age.

(BTW, I don't participate in an Amazon affiliate program, just wanted to share what got me thinking)

July 23, 2014

Major divergences

As we're seeing one of the best earnings seasons in recent memory, meaningful divergences are showing up in market breadth.  This is going to a problem for the market at some point in the near future.

We see the NYSE stock only advance-decline line is barely bouncing after the major breadth sell-off of the past couple of weeks.


The highly concentrated Nasdaq ETF QQQ has reached new price highs while the Nasdaq Composite has not.  We can also see the major divergence in the A-D line.


Let's not forget the major divergence in high yield corporate bonds. 


Also every measure of risk in the bond market has been flashing caution for awhile now, but it just hasn't mattered.  

The example I've shared time and again on stocktwits and twitter:  the high yield to investment grade corporate bond ratio is breaking down below the largest top in the history of these ETF's.


These divergences are definitely warning signs, but we can't act like the markets will immediately acknowledge this.  They haven't.  

It feels impossible that these divergences are setting up with all our favorite large cap stocks crushing earnings and trading higher, but that's what the market does.  

It's smart to be skeptical of the rally, but there is no logical option but to wait for an evident reversal to take a shot short.  Who knows when that'll be, but it feels like it may not be too far off.  Until then, we can ride the large cap fund faves on the long side.   

July 20, 2014

Swing low in?

We all know this has been a buy the dip market.  Was Thursday's drop the culmination of another dip?  If the stock only A/D line is any indication, yes!  


Of course it's pointless to use a single indicator in any market decision making, but the recent track record is interesting.  That said, we're seeing the largest rollover in high yield bonds in a year.  Maybe this time is different?

Trade 'em well!

Reminder:

All ideas shown on this blog represent the authors opinion based on the data available.