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.