A History Lesson From 2006 and 2007

It was obvious by late 2006 that the real estate bubble was beginning to deflate. Leveraged speculators were starting to get into trouble and the housing market was slowing down. With all the leverage in the system it was a certainty that the collapse would be massive. Let me refresh your memory if you forgot: 108% no money down mortgages, liar loans, janitors getting $500,000 mortgages, no doc, no problem.

Despite the writing on the wall the market steadily climbed through late 2006 and all the way until the summer of 2007. There were some hiccups during the year when a number of subprime lenders collapsed but the market recovered quickly each time. There were some bigger hiccups that Summer when problems began to surface at larger banks but the market still did not not put in a high until October of 2007.

By October of 2007 the problems were painfully obvious. The economy was slowing and the real estate bubble was quickly deflating. Shouldn't the market have realized this instead of making new all time highs? Isn't the market a discounting mechanism? What was the reason the market kept climbing?

The answer to this mystery was quite simple. There was a boom happening in M&A, LBO and share repurchases. The supply of stock was quickly shrinking. It seemed like every other day there was a massive share repurchase, LBO or M&A announcement.

I remember this period very clearly because I was short. My saving grace was that I bought SPY leap puts when the VIX was at 10 so it allowed me to weather the market going against me. While this trade turned out to be the trade of my lifetime it was a grueling experience. Knowing for certain that the economy was collapsing, yet watching the market go against me every day was painful. If I were managing OPM at the time I likely would not have been left with much money.

This period ingrained into my head the power of share repurchases and cash M&A. The market was able to shrug off subprime companies collapsing, banks running into trouble and a slowing economy. It wasn't until the economy choked off the M&A and share repurchases that the market collapsed.

I was reminded of this experience in the past week as TrimTabs reported that there was nearly $100 billion in cash M&A and share repurchases in the last 2 weeks. Than on Friday it leaked that Wal-Mart, the nations largest retailer, was having one of their worst starts to a month ever. The main culprit being the payroll tax hike. The market dived at first but by the end of the day the Dow was up.

I don't believe a collapse is imminent like I did in 2007, even though there are no shortage of imbalances and risks. The reason I tell this story is that if the share repurchases and cash M&A continue at the recent pace it is likely to trump any fundamental factors.

Light My Fire

In my outlook for 2013 I wrote:
The level of cash M&A, LBOs and share repurchases have been on the low side considering where rates are. A buyout boom fueled by low rates is a real possibility. The fuel is there. Somebody just needs to light a match.

In the past two weeks there has been $97.5 billion in cash M&A and share repurchase announcements. TrimTabs has done extensive studies on what they call float shrink. This extreme level of float shrink is very bullish in the short term. It is intuitive that less supply of stocks should lead to higher prices.

Unfortunately, other factors are not as rosy for the market. Sentiment is excessively bullish and valuations are full. At the same time we are about to see the effects of the payroll tax hike. Many Americans live paycheck to paycheck and a broad tax hike is likely to effect the economy. There are also likely to be spending cuts even if we don't see a sequester.

It seems that the market is setting up for a third bubble. In the same way that artificially low rates have driven up real estate prices it seems the same is now happening to stock prices. This will likely not end well but being early to try and fight this is the same as being wrong.  The facts have changed with the massive amount of M&A and share buybacks announced in the past 2 weeks. I have bitten the bullet and removed some of my hedges, accepting a very low level of market risk.


There has been an undeniable change in recent weeks but it is not an economic change. The economy continues to muddle through while corporate profit growth is slowing. The major change has been one of psychology. Investors are suddenly feeling comfortable with more risk and have been shifting their exposure towards equities. After years of obsessing over risk management investors have shifted their attention towards rewards.

Hedge fund managers have been increasing their gross and net exposure as every survey and prime broker report has shown. Large asset allocators  such as family offices and pension funds are suddenly more comfortable with long only exposure as assets have been exiting bonds and hedge funds.

I prefer to buy at times when uncertainty is high and stocks are cheap. While in the long run this strategy has worked for me there can be long periods of time where I miss the party. There is no reason the  market cant stay overvalued and participants remain over bullish. In the past the market has stayed overvalued for years at a time and it can happen again. In a relative performance world these sort of rallies tend to persist until they suck everybody in.

I continue to remain patient and am finding very little to buy. I have been selling stocks when they reach my price target but have not been able to replace many of them. The winds have indeed shifted but I am remaining patient. If one thing is for certain is that sentiment will one day cycle back to excess pessimism and when that happens I will be ready to buy.

The Great Rotation Myth

The rallying cry of the bulls has been a "Great Rotation" out of "safer" assets like bonds and into "riskier" like stocks. The argument goes that stocks trade at fair valuations but are relatively cheap compared to bonds of all stripes. There are many flaws in this argument but the main reason I don't believe we are at the beginning of a "Great Rotation" is demographics. The baby boomers are in or near retirement and a secular move into riskier assets is unlikely to occur under these conditions.

It is undeniable that there has been a rotation into riskier assets in recent months. Hedge fund surveys and actual positioning reports from broker dealers show higher gross and net exposures from hedge funds. Sentiment surveys like the NAAIM & AAII combined with inflows into stock funds show that advisers and the public have had a  stronger risk appetite as well. While data on institutions is sparse, I have been hearing anecdotal evidence that they are feeling more comfortable with riskier assets. I believe this is  a cyclical rotation seen in the latter parts of a bull market rather than the beginning of a secular move.

The following excerpt on baby boomers comes from Wikipedia:
baby boomer is a person who was born during the demographic post-World War II baby boom between the years 1946 and 1964, according to the U.S. Census Bureau

... Baby boomers control over 80% of personal financial assets and more than half of all consumer spending

The oldest baby boomer is now 67 years old. By 2020 more than half of baby boomers will be over the age of 65. The vast majority of pension assets are for the retirement of the baby boomer generation. A great secular move towards risk seems highly unlikely to me when the group that controls the majority of assets are heading towards retirement or already in it.

I believe it is far more likely that we are in the latter part of a cyclical bull market than at the beginning of a "Great Rotation" and secular move into risk assets. We have had a four year bull market where the S&P 500 has had a total return of roughly 135%. This "Great Rotation" argument is a rationalization for those who have missed the move to follow their primal instinct to herd. "The Internet Is The Future" was the rationale for throwing caution to the wind during 1999. While the slogan was true the investment implications were disastrous. With that said, the market did not top out for another year after we started hearing that catch phrase.