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Bears Dazed and Confused by M&A

Deal-making in several sectors brings out the bulls ahead of an uncertain midterm election.

Monday's deluge of M&A activity is a reminder that there's still a

whole lotta liquidity

sloshing around the financial world.

The announcements of deals totaling about $20 billion Monday morning eclipsed midterm election angst, rising oil prices, hawkish


-speak and the specter of rate hikes. The deal-making reignited the bullish view that the economy is strong, profit growth can keep going and stocks are still undervalued.

"M&A is a sign of confidence," says James Paulsen, chief investment strategist at Wells Capital Management. "People wouldn't do these deals if they thought everything is going to hell."

On that note, the stock market rebounded solidly Monday after a string of weak sessions. The

Dow Jones Industrial Average

added 119.5 points, or 1%, to 12,105.55, while the

S&P 500

gained 1.13% to 1379.78. The

Nasdaq Composite

registered a gain of 1.51% to 2365.95.

"M&A is an extreme example and another reminder that there are oodles of excess liquidity out there," says Paulsen. Evidence of still-loose liquidity can be found in the record, $285 billion of U.S. private equity deals announced this year, according to Thomson Financial, as well as $1.37 trillion of overall M&A activity, up 28% from the same point in 2005. Add to that tight credit spreads, low default rates, record levels of corporate stock buybacks and soaring commodity prices, excluding energy -- although crude moved back above $60 per barrel Monday.

The financial markets have followed the "data dependent" Fed's advice lately, reacting to the latest economic news to guide day-to-day moves. But the overarching message about the strong economy isn't lost on investors despite volatility, argues Paulsen. He believes the stock market rallies not on the notion that the Fed will cut rates but on the idea that the economy is strong, which means profits will continue to be robust.

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Indeed, investors have gotten used to strong profits and relatively low price-to-earnings multiples to fuel their stock portfolios. In this nearly four-year bull market, the pace of profit growth has been faster than stock price increases, leaving stocks looking relatively cheap by this measure, says Paulsen.

M&A deals highlight this valuation argument. Any deal becomes "an example of what could happen to all the other stocks you think are undervalued," says Paulsen. Why wouldn't investors react positively to whatever news keeps this stock market phenomenon in play, even if rate hikes come back into the picture? Amid 17 rate hikes from 2004 to summer 2006, the market kept going up.

Monday's M&A activity included a $3.7 billion buyout offer for

Four Seasons Hotels


at a 28% premium from its closing price Friday. The offer is being led by Isadore Sharp, Four Seasons' CEO and controlling shareholder, and backed by Kingdom Hotels International, a firm owned by Saudi Prince Alwaleed, and Cascade Investment, a private equity firm owned by Microsoft founder Bill Gates. Four Seasons' board is considering the deal, and the company's shares jumped 29.17% Monday.

Sympathy (or jealousy) rallies ensued elsewhere in the hotel sector.



gained 9.6%, while shares of


(HLT) - Get Hilton Worldwide Holdings Inc (HLT) Report




each added over 3%.

In the pharmaceutical sector,

Abbott Laboratories

(ABT) - Get Abbott Laboratories Report

agreed to buy

Kos Pharmaceuticals


for $78 per share, or a 56% premium. The news sent Abbot's shares down 0.36%, but Kos stock gained 53.8%. The Amex Pharmaceutical Index gained 1.09% on the day.

Private equity firms Bain Capital and Catterton Partners announced plans for a $3.2 billion buyout of

OSI Restaurant Partners


, the company that owns the Outback Steakhouse. Its shares gained 22.4%.

In other M&A news,

Kinross Gold

(KGC) - Get Kinross Gold Corporation Report

agreed to buy



for $2.8 billion in stock; Bema shares rose 12%. Meanwhile,

Per-Se Technologies

(PSTI) - Get Pluristem Therapeutics Inc. Report

gained 12.7% on news of a $1.8 billion buyout offer from


(MCK) - Get McKesson Corporation (MCK) Report


The excess liquidity in the market -- in part supported by pessimistic Treasury bond investors betting the economy is in bad shape -- has kept corporate borrowing costs relatively low. That means private equity deal flow is unlikely to disappear anytime soon, says Margie Patel, portfolio manager at Pioneer Investments. These private equity investors get yield and asset value exceeding their cost of borrowing, she says.

"Who wouldn't borrow at today's rates to buy tangible corporate assets?" says Patel. "If you just arrived from Mars with a bunch of money, you'd say, 'a lot of these companies have cash flow of 5% to 6% and growing.' If you could buy your own company, you'd say, 'That's a good idea.'"

The liquidity comes from a fed funds rate kept at 1% for too long, Dallas Fed President Richard Fisher admitted in a speech last week. He acknowledged the Fed kept rates too low, too long because of misguided inflation data, which suggested the economy was heading into a deflationary environment. (Conversely, former Fed Chairman

Alan Greenspan said Monday at a Schwab conference in Washington that there were no decisions made during his tenure that, in retrospect, he would have made differently.)

Comments Monday by typically hawkish Chicago Fed President Michael Moskow suggest the Fed is likewise concerned about going too far in the opposite direction, as it is pausing to see what the effect of 17 rate hikes will be. But Moskow emphasized the strength of the economy and reiterated that stimulative rate cuts are not on the horizon.

Moskow said at a Chicagoland Camber of Commerce breakfast that "current financial conditions are not very restrictive by historical norms," and that he expects GDP growth to pick up from the estimated 1.6% third-quarter pace, but remain slightly below 3% potential. "On balance, the 95% of the economy outside of housing remains on good footing," he said.

On inflation, Moskow acknowledged that core inflation is running over his comfort level, but agrees that it is likely to come down "somewhat, over time." The risk, he says, is for inflation expectations to increase, which leads to adjustments in prices and wages, thus causing more real inflation to take hold.

Under such circumstances, the Fed would "adjust policy," he said.

The markets listened. Odds of a rate cut in March fell to 12% from 56% last week, according to Miller Tabak. Odds of a rate hike at the January FOMC meeting reappeared at 4%.

So, stocks march into election day, drunk on M&A nectar. But in this uncertain environment, Tuesday could bring a blinding hangover.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


to send her an email.