Dow Dances to Mergers' Song

Speculation about a potential Alcoa buyout brings out bulls ahead of Bernanke's Capitol Hill testimony.
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Call it a

Dow

day, but certainly not a down day.

M&A speculation about

Alcoa

(AA) - Get Report

, a Merrill Lynch upgrade of

General Motors

(GM) - Get Report

, and a $7 billion share-buyback from

3M

(MMM) - Get Report

were enough to inspire the bulls on what typically would be a quiet day ahead of the

Federal Reserve

chairman's semiannual testimony on Capitol Hill.

The Dow Jones Industrial Average jumped 0.8%, or 102 points, to close at 12,654.85.

GM's recent strong performance and a potential Alcoa acquisition, in particular, "reconfirm" Wall Street's more-than-seven-month rally, just as the Dow Jones Transportation Average "confirmed" the rally two weeks ago by hitting a new high, says Margaret Patel, portfolio manager at Pioneer Investments.

For investors to bid up GM, they have to believe that the U.S. consumer and economy are in good shape, says Patel. For Alcoa to be acquired for $40 billion, whoever is buying it must believe that the global economy is strong, and that the metals and basic materials boom is far from over, she says.

Investors awakened to news reports that aluminum maker Alcoa may be the target of mining giants

BHP Billiton

(BHP) - Get Report

or

Rio Tinto

(RTP)

.

Alcoa rose 6.2% Tuesday. It has returned 16% year to date, and is up 15.5% from this time last year. BHP and Rio Tinto gained 2.4% and 3.1%, respectively, on the day.

Meanwhile, Merrill upgraded GM to buy, citing the automaker's strong liquidity. GM gained 2.6% Tuesday, and the stock is up 19% year to date and 66.5% over the past 12 months. Investors focused less on Merrill's simultaneous downgrade of

Ford

(F) - Get Report

, though shares of the company fell 2.5%. The transports average added 1.5% on the day.

3M's announcement of the biggest buyback in its history sent shares of the conglomerate up 2.4% and also helped boost overall market sentiment. The

S&P 500

added 0.8% on the day to close at 1444.26, while the

Nasdaq Composite

rose 0.4% to close at 2459.88.

But it was M&A that fired Tuesday's rally.

"Acquisitions don't happen at bottoms," says Patel. "They happen when the target stock has moved up, but not all the way up. It indicates the buyers are optimistic about the basic business. If you're heading into an economic downturn, you're not going to buy a company, borrow money, and go through it."

Speculation about Alcoa comes on the heels of another recently announced, albeit smaller, metals merger. Indian aluminum and copper company

Hindalco Industries

announced over the weekend that it has offered $5.9 billion for Canadian aluminum producer

Novelis

(NVL)

. Novelis was up 0.4% Tuesday after surging 13% Monday.

Other metals companies rose in concert with Alcoa. Copper maker

Freeport McMoRan

(FCX) - Get Report

, which is in the process of buying

Phelps Dodge

(PD) - Get Report

for $25.9 billion, rose 5.5% on the day. Phelps gained 1.8%.

Outside the metals mania, drugstore operator

CVS

(CVS) - Get Report

boosted its offer price for

Caremark

(CMX)

as it tries to fend off a rival bid from

Express Scripts

(ESRX)

. CVS fell 1.2% on the news, while Caremark jumped 3.2%.

Traders were unfazed by the widening trade deficit, which ballooned to $61.2 billion in December from $58.1 billion in November, according to the Commerce Department. Higher oil imports widened the gap.

Several economists noted that the wider deficit will shave off about a quarter-point from the government's initial estimate of 3.5% growth in fourth-quarter GDP, with some saying it will send growth below 3% for the period.

Bernanke in Softer Spotlight

Behind the screen of a rallying Dow, the deficit news brings back into focus Fed Chairman Ben Bernanke's testimony before the Senate Banking Committee Wednesday. The chairman will testify before the House Financial Services Committee on Thursday.

Last July, when Bernanke gave his second monetary policy report on Capitol Hill, the Dow rallied 210 points, even after Sen. Jim Bunning (R., Ky.)

accused Bernanke of being incompetent and spurring stock market declines.

Most don't expect this week's testimony to have such an impact on the market. This time around, the chairman is a more of a known quantity, and the Fed and the markets are in sync, wholeheartedly believing the central bank will keep rates on pause until late in 2007.

"A 5.25% federal funds rate seems to be just what the doctor ordered: the maintenance dosage of monetary medicine to keep this happy combination intact, until or unless the economy shows different symptoms," writes Neal Soss, chief U.S. economist at Credit Suisse. "We think that's exactly what Chairman Bernanke will signal with his testimony."

Soss adds that Bernanke likely will repeat what Fed speakers have recently drummed into traders' heads -- that inflation risks remain, but the economy is in good shape.

Soss' confidence in Bernanke's current policy is a far cry from the sentiment during the Fed chairman's early days in 2006, when he was struggling for credibility and flexibility. Now, the markets seem to have placed their trust in Bernanke to maintain this strong growth, and to keep inflation in check.

Indeed, Tuesday's pre-testimony buying spree is a testament to investors' faith that Bernanke will not upset the apple cart.

Last summer, Bernanke was still reeling from his rookie mistakes, namely his offhand remark to

CNBC

's Maria Bartiromo about the market's incorrect interpretation that he's a dove. The newly anointed chief was fighting for authority, as stocks had languished since May 2006, and investors perpetually expected the next FOMC meeting to ring in the last rate hike.

But by autumn, the market was back in an upswing, the Fed had stopped raising interest rates after 17 consecutive increases, and the economy was starting to land softly.

Investors have now embraced Bernanke, and many give him credit for engineering a so-called Goldilocks economy marked by decent economic growth without high inflation. Bernanke has to show the markets that he's vigilant about inflation, but he also has to "give himself the flexibility to not act or raise rates because of one piece of data," says Patel.

If he sticks to the recent script, the markets' tall order likely will be filled.

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

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