If the first half of 2007 was characterized by a crescendo of risk appetite, embodied by record highs for major averages and blockbuster M&A activity, the second half is likely to be differentiated by a more sensitive stomach. Signs are emerging of the end of the easy money leveraged buyout boom, which could cause indigestion for corporate bond and stock investors alike.The bull market isn't necessarily over, but the path ahead is likely to be rockier than in the first half of the year, when the Dow Jones Industrial Average rose 7.6%, while the S&P 500 gained 6% and the Nasdaq Composite gained 7.8%. Despite the gains, a late February/early March swoon and the more recent failure of two Bear Stearns ( BSC) hedge funds awakened investors to the dangers of a credit crisis. A "credit crunch" has been averted thus far, but the fallout has included struggles for several leveraged buyout-related deals to get priced in the junk bond and leveraged loan market. The key question has become how fast and furiously liquidity will drain out of the credit markets, and what the ensuing ripple effects will be on the stock market. "It could be a quick crash and burn or a slow-motion train wreck," says T.J. Marta, fixed-income strategist at RBC Capital Markets. By crash and burn, he means a crisis involving a contagion effect where more hedge funds implode as collateralized securities, called CDOs, are repriced at much lower levels, causing lending standards to tighten up, banks to make margin calls, and hedge fund investors to dump assets to cover their losses. The slow-motion train wreck, on the other hand, would be a more gradual tightening of lending standards that results in wider risk premiums and incrementally restricts low-quality companies' and individuals' access to credit.
In this latter scenario stocks may still end the year higher, but due more to factors that counterbalance any credit tightening such as a reaccelerating U.S. economy and still ample liquidity amid a global M&A boom. Global M&A volume hit $2.88 trillion in the first half , up 55% from the same period a year ago, according to Dealogic. The takeovers, plus 26 share buyback announcements of $2 billion or more, are literally shrinking the stock market -- a bullish phenomenon even if
demand remains static . But a tightening process is underway as deals to finance some buyouts have recently faltered. The financing for the Kohlberg Kravis & Roberts and Clayton Dubilier & Rice buyout of Ahold's ( AHO) U.S. Foodservice unit was shelved last week. This week, a similar fate befell the deal to finance Clayton, Dubilier & Rice's buyout of ServiceMaster ( SVM). Other deals like Dollar General's ( DG) had to be restructured and priced with higher coupon payments to better entice potential investors. "Investor resistance to such deals likely highlights the bottom for lending willingness, and a shift back to more conservative lending would be a healthy sign for the market," writes Jeffrey Rosenberg, head of credit strategy research at Bank of America. He adds that investors will likely have the upper hand from now on in these markets to finance LBOs as $90 billion in bonds and $200 billion loans taxi onto the deal-flow runway.
Indeed, these mid-year hurdles come just as private equity firms will be attempting to financing the largest and more controversial buyouts that were announced in the credit worry-free days of early 2007. These include: Chrysler's ( DCX) $7.9 billion deal, TXU's ( TXU) $45 billion deal, Tribune Co.'s ( TRB) $8.2 billion buyout by Sam Zell, and First Data Corp.'s ( FDC) $29 billion buyout. "Everyone remembers that in October of 1989, United Airlines couldn't secure financing for it's leveraged buyout, and the stock market fell 6%," says James Bianco, president of Bianco Research. "What if Sam Zell can't get financing for Tribune? The minute that hits the tape, the next 10 deals behind it are dead too. That's what's bothering the market."
Amid such anxiety, the stock market is likely to be more volatile and the flight to more defensive stocks is likely to become more pronounced, says Citigroup's chief U.S. equity strategist, Tobias Levkovich. So far this year, the large-cap S&P 500 is neck and neck with the small-cap Russell 2000 after several years of small-cap outperformance. Bank of America's chief equities strategist Thomas McManus agrees. "We expect large capitalization stocks to continue and extend their recent 'catch-up' trend compared to small caps," he writes. The large-cap thesis meshes with expectations for more strong earnings reports to come out of big multinational corporations this year amid a reaccelerating U.S. economy, strong global growth, a weak dollar supporting exports, and a Federal Reserve expected to be on hold until 2008. Indeed, companies like Nike ( NKE) noted new orders in the U.S. trailed far behind sales in regions like Asia, and Africa and Europe, while companies like Best Buy ( BBY), with a purely North American footprint, missed expectations by a mile, says David Dropsey, senior analyst at Thomson Financial. Growth sectors like technology may also benefit from a weaker M&A backdrop, but a strong economy. Funds raised by companies in the easy money years could be channeled into business spending and capex improvements rather than into buying other companies, writes Richard Berner, economist at Morgan Stanley. "It is crucial to differentiate between a welcome tightening of lending standards that slows the pace of buyouts and a credit crunch." One sector to avoid may be investment banks and brokerage firms, which suffer from credit market tightening, and which have seen higher levels of insider selling in June, says Mark LoPresti, vice president in Thomson's proprietary research group. LoPresti mentioned increased selling at Bear Stearns, Goldman Sachs ( GS), and Lehman Brothers ( LEH) while noting insider buying has risen in the healthcare sector and financials, excluding investment banks and brokerages. As the credit market shakes out its excesses in the second half of 2007, an otherwise strong fundamental backdrop may make the markets handle like a finely tuned sports car hampered by a soft tire. If that tire totally deflates, investors will either just stop and find a spare in the trunk or must sit idly at the side of the road and wait for help.