While developing economies struggle to raise money to support growth, U.S. companies are using this period of ‘ultra-low’ interest rates to issue debt.  The chart below shows how investment grade debt issuance has surged to over US$600 billion per year, with over 1/3 of that being dedicated to corporate acquisitions.  We estimate that a substantial amount of those funds are also being directed towards stock buybacks, which increases earnings per share and supports higher stock prices, but does nothing to enhance overall economic growth.

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This is the crux of our argument that these Zero Interest Rate Policies (ZIRP) have done very little to enhance economic growth and are, in fact, becoming less effective with each subsequent policy.  In the U.S., the impact on the economy of QE3 has been far less than QE2, which was also less successful than QE1 in stimulating growth.  The policies have been successful in terms of raising the risk levels of investors as they are forced to take higher levels of risk in order to achieve historical income levels.  Also, as shown earlier, the policies have encouraged companies to engage in acquisition activities to enhance growth.  The chart below shows the pick-up in Merger and Acquisition (M&A) over the past two years and how it mirrors the surges in M&A prior to the last two stock market peaks, in 2000 and 2008.  When growth slows down and companies can’t generate organic earnings growth then they often turn to M&A in order to supplement growth.  Putting two companies together, cutting overlapping costs and getting some revenue synergies often leads to a period of greater earnings growth and is particularly attractive in a period of low interest rates.  Companies such Couche-Tard, CGI Group and Valeant Pharmaceuticals have used these ‘roll-up’ strategies over the past few years to augment core growth.  However, in the case of Valeant, investors can quickly turn very bearish and stock prices can fall precipitously if the debt levels become too high or the acquisition targets become less attractive.

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The bottom line is that elevated levels of M&A are more indicative of the late stages of a bull market in stocks.  The substantial pick-up in this activity over the past two years is just one more sign of the increasing level of risk in the stock market and just another reason why we remain cautious about the outlook for stocks.

Our caution on stocks come from the artificial support for stocks that was created by excessively low interest rates as well as the record level of corporate buybacks.  Most valuation measures we look at are also at the high end of historical ranges including the price-earnings ratio of the overall market as well as the Q-Ratio (stock market vs GDP).  Another measure that shows how stretched stock prices are is the very long-term regression Trend Line for the S&P500, probably the most appropriate measure of a large, globally-oriented stock index.  The chart below, courtesy of dshort.com, shows the value of the S&P500 today being 85% above the long-term regression trend line.  This level has only been exceeded twice; during the technology bubble in 2000 and before the stock market crash of 1929.  On the other side, the S&P500 Index was at a 14% discount to this trend line when it bottomed in March of 2009.

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