Will Buybacks, Deals Fail as Cheap Money Dries Up?

You know how you’re supposed to build value as a corporate executive? Invest in property, plant or labor. Develop compelling new products that solve real problems. Drive earnings through increased sales.

You know how many executives are actually boosting shareholder value instead? By taking cheap, easy money and buying back their own shares, acquiring competitors and firing workers, and otherwise engaging in a massive game of financial engineering.

Just consider these amazing statistics:

==> Total deal volume in the U.S. is running around $2.2 trillion this year. That’s more than double the level at the depths of the 2008-09 recession, and a whopping $500 billion above the credit bubble peak in 2007.

==> Dealogic counts 48 mega-deals (those worth $10 billion or more) so far this year. Their total value: $1.35 trillion. That has now topped the previous record of 40 for $1.17 trillion … set in the dot-com bubble peak year of 1999.

==> Stock buybacks surged to $492 billion in 2014, and are running at almost that level this year. Those are roughly the same as we saw at the credit bubble peak in 2007.

Buying beer with $104.2 billion in easy money?

Then this Monday, we learned that Dell would officially team up with the private equity firm Silver Lake Partners to buy storage technology company EMC. The price tag? $67 billion, or almost double the previous largest tech merger in history (Avago Technologies’ $36.5 billion offer for chipmaker Broadcom).

On Tuesday, Anheuser-Busch InBev NV (BUD) sweetened its offer for SABMiller Plc (SBMRY) to $104.2 billion. If the transaction ultimately garners regulatory and antitrust approval, it will be one of the largest in history.

That same day, medical device and drug firm Johnson & Johnson (JNJ) reported disappointing third-quarter results. Per-share profit fell to $1.49 from $1.61 a year ago, while revenue came in at $17.1 billion – well short of the $17.5 billion analysts expected.

But rather than double down on R&D or marketing spending, or otherwise invest more money in its business to boost growth, J&J whipped out the financial engineering card! It said it would buy back up to $10 billion of its own shares, borrowing the money to fund the program.

Bottom line? Easy money hasn’t accomplished much of anything for the real economy. But it has helped executives pad their bonuses and artificially prop up share prices.

The problem going forward is that the easy money flood is starting to dry up. As the Wall Street Journal noted on Monday … and as I’ve written repeatedly in the past several months … high-yield (junk) bond prices are falling. Yields on riskier debt are rising. Debt downgrades are climbing and corporations are more leveraged relative to underlying core earnings than they’ve ever been.

All of that tells me we are either at or very near the peak in the M&A and buyback bubbles. That, in turn, means the major stock averages are losing a key prop that has inflated prices above and beyond fundamental value.

So at the risk of sounding like a broken record, make sure you take advantage of bounces like we saw in early October to lighten up on equity exposure. Hedge against downside risk by adding inverse ETFs and put options on rallies, as I’m doing in my Interest Rate Speculator service. Maintain much higher levels of cash than you did during the six-and-a-half-year bull market. And keep a steady hand on the tiller as volatility is likely to pick back up before long.

Until next time,

Mike Larson