It’s been a busy year for mergers and acquisitions (M&A) in both the United States and Canada. Dealogic has tracked US$637.95-billion worth of M&A so far this year in the U.S., the fastest start to any year since the researcher began tracking deals in 1995. We have seen over 170 deals over the past three months totalling over $1.5 trillion in total value! One of the strongest areas for M&A activity in the past quarter has been energy, which had three of the top 10 deals for the period — the best performance for the sector since the fourth quarter of 2012.

Historically, when management moved to scoop up another company, it was the target whose shares climbed. After all, one company is taking a risk and throwing down cash, while the other is getting a vote of confidence in its business. But recently we are seeing the stock of the acquiring company rise as well because the purchases are generally adding to earnings as companies exchange low-yield cash for productive assets. With companies sitting on record piles of cash, interest rates low and pressure from shareholders to expand, we will probably see more of these ‘accretive’ acquisitions.

The other activity that has supported stock prices has been the continual buyback activity of companies. With corporate cash levels at all-time highs, interest rates at lows and companies still reticent to resume major capital expenditures, the most popular use of corporate cash has been to buy back the company’s stock. This has the added benefit of increasing earnings per share for the company as the net income is being divided by a smaller numbers of shares after the buybacks. The chart below shows how this buyback activity (height of bars in chart) has picked up since the last recession and is now closing in on the record levels set back in early 2008. The solid line shows the level of corporate cash in the U.S. The current level of over US$1.4 trillion is just below the record high set last month. At some point, however, companies have to start channeling their excess cash into other, more productive, activities in order to sustain growth. The record level of corporate merger activity discussed earlier is certainly one of those alternatives.

Company Earnings Boosted Through Share Buybacks

Many investors are getting more cautious in the short term for the simple reason that stocks have not had a serious (over 10%) setback in over two years. While that is not typical, it has occurred before (1993-1997). One of the bigger concerns for shorter-term investors has been the record low level of volatility in the market. The Volatility Index (known as the ‘VIX’) has traditionally been used a measure of the amount of investor apprehension, or ‘fear’, about the outlook for stocks. While not a perfect ‘market timing tool’ by any stretch of the imagination, the VIX has tended to rise during periods of market downturns and head lower when times are good for stocks. The chart below shows the path of the VIX over the last ten years. It sky-rocketed in 2008 during the financial crisis and then peaked in late 2008, just a few months before the ultimate low in stocks. It then rose sharply in 2010 and 2011 again, just prior to market downturns in each of those years. Since then we have seen the VIX head lower, with the recent level of 11.58 being the lowest since prior to the financial crisis in 2008. This ‘complacency’ or lack of fear about the outlook for stocks makes contrarians very nervous. While a low in the VIX does not mean a correction is imminent, it certainly has coincided with periods of market peaks in the past.
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So the VIX may be giving a shorter-term ‘buyer beware’ signal, the fundamentals of the stock market don’t really give cause for the same concern. The forward earnings multiple on the global stock market right now is about 16 times, right in line with the long term average of 15.5. So while we can no longer argue that stocks are ‘historically cheap’, it’s hard to argue that they are expensive, particularly given that interest rates are near historic lows. Periods of low interest rates in the past have also coincided with periods of higher stock earnings multiples. This relationship between stocks and interest rates suggests that earnings multiples could rise further still. The relationship between interest rates and stock earnings is shown more clearly in the chart below, which shows the difference between the yield on 10-year government bonds and the earnings yield on stocks. The greater the number, the more under-valued stocks are compared to bonds. This difference was actually negative for a brief period at the top of the ‘tech bubble’ in stocks in 2000. It then reversed over the next twelve years and reached a high in early 2012, just before stocks began a two-year rise. While the rally in stocks has reduced this difference over the past two years, the chart shows that, at around 4%, stocks are still a better choice over bonds!

Stock Values vs Low Bond Yields But we might see ‘stock sector rotations’ rather than full scale market downturns over next few quarters. While various sectors of the market have intermittently been leaders and laggards over the past few years, there have been some serious sell-offs within sectors over that time; witness the 50% fall in gold stocks in 2013 and the quick 15% drop in the ‘formerly high flying’ internet and biotech sectors earlier this year.

One of the rotations we are seeing this year is the move from slow-growth, defensive stock groups such as utilities, consumer staples and telecom into the ‘cyclical’ industries that see stronger growth when the global economy is expanding at a faster rate. Leading groups so far in 2014 have included the industrials and energy. We continue to hold overweight positions in Basic Materials (primarily base metals and agricultural stocks such as Lundin Mining, First Quantum Minerals and Agrium), Information Technology (Blackberry, Open Text and CGI Group in Canada and Apple, Facebook, Google and Qualcomm in the U.S,) and Energy (Athabaska Oil, Crescent Point Energy, Long Run Exploration, Legacy Oil & Gas, Trinidad Drilling and Whitecap Resources). We also continue to hold significant positions in Air Canada (strong operational turnaround and upside to valuation), Catamaran Corp. (great long-term growth from the move in health care to pharmacy benefits exchanges and the roll-out of the Affordable Care Act in the U.S.), Valeant Corp. (strong earnings gains from expected success of Allergan acquisition) and the Canadian bank stocks for their solid fundamental growth, moderate valuations and dividend growth. While we have reduced our overall stock weight to average levels over the past month due to some shorter-term apprehension about further market gains, we would be adding back to existing positions on any market pullback in excess of 5%.

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