Merger Menace?

More takeover activity drove the stock market to new highs today, with the S&P 500 briefly trading above its all-time closing high before dropping back in the afternoon. Bloomberg News reports a total of $1.04 trillion in takeovers so far this year, up 69% from the same point last year.

One might ask why this is so exciting. Obviously the profits can be handsome if you happen to own a stock that is bought out at a premium. Yet the real significance is in what this activity tells us about the rest of the stock market. While bears fret about stocks being "overvalued," the people who have the ability to buy entire companies clearly think that there are plenty of bargains at today's prices. Since these are generally pretty smart people, and they are willing to put their money on the line, it is hard to argue they are wrong. Therefore, stocks in general must have plenty of room to go higher.

The other angle is simple supply and demand. When private-equity firms buy a company, the overall supply of stock available to be bought goes down. To some extent it is replaced by new public offerings, but lately the value of IPOs has been lagging the value of takeovers. Hence we have a net drop in the supply of stock to buy, at the same time demand for stock is growing. This spells higher prices.

The people who are taking companies private typically plan to buy a company, fix it up, install new managers, then sell it again at a profit. This process can take several years to unfold. At some point, however, much of the stock supply that is now disappearing will again emerge into the public marketplace. When we enter that phase the market will probably be much closer to a major top than it is now. This doesn't mean more gains are guaranteed in the short term, of course. For the moment, however, the path of least resistance is up.