The Single Most Important Chart for 2014
“The only thing we have to fear is fear itself.”
Franklin D. Roosevelt spoke those incredible words 80 years ago, which were then echoed by John F. Kennedy in 1960.
But what would happen if we didn’t even fear, well… fear itself?!
As I survey the landscape heading into 2014, there’s no fear anymore. Anywhere.
I’m talking about the type of fear that overwhelms investors – and, in turn, the market.
Doubt me? Take a quick trip down memory lane. You’ll soon realize many things that once scared us stockless simply don’t exist anymore.
There’s no fear about a U.S. financial and economic collapse. Banks are on the mend and the economy is actually exhibiting signs of strength.
There’s no fear about a eurozone crash.
There’s no fear about a hard landing in China.
There’s no fear about a debt ceiling default, either. The latest budget deal points to politicians finally working together.
Heck, even the “fear index” itself – the VIX Volatility Index (VIX) – hasn’t registered a meaningful blip over 20 since December 2012.
That begs the question, though: Without an imminent crisis gripping investors – and no “end of the world” trade being touted tirelessly – what are we to do?
A single chart contains the all-important answer. And no, it’s not an unabashed bullish call to go “all in” on stocks.
Fear Bubble: Deflated!
Forget about the stock market rising on bubble expectations. In the words of Eddy Elfenbein of Crossing Wall Street, it’s rising on the “tremendous fear bubble deflating.”
The surest indication of this can be found in the following chart:
It shows the spread between high-yield bonds (junk bonds) and super-safe Treasuries of comparable maturity.
After touching a high of 2,180 basis points following Lehman Brothers’ collapse – when outright panic gripped the markets – spreads are all the way down to 411 basis points. That’s more than a full percentage point below the long-term average and the lowest since October 2007.
What does it all mean? As I said before, there’s no fear.
Lenders are willing to lend. Rightfully so, too, as the default rate for junk bonds dropped to a measly 2.4% in November, according to Barron’s, which is about half the long-term average default rate.
Getting back to yesterday’s conversation about the imminent uptick in mergers and acquisitions (M&A) activity, the super-low spreads promise to encourage much more dealmaking.
How so? Well, instead of being forced to pay cash, companies can now leverage their purchasing power by funding the deals with more debt.
By the way, companies are sitting on a staggering amount of dry powder right now. In the third quarter, cash held by U.S. corporations rose by 6%, to $1.925 trillion, according to Federal Reserve data.
To put that amount into perspective, consider that the value of worldwide M&A totaled $1.7 trillion during the first nine months of 2013, according to Thomson Reuters’ latest Mergers & Acquisitions Review.
So if companies finance 50% of deals, we’re talking about enough buying power to easily double the amount of M&A activity we’ve witnessed in the last nine months.
I’m not saying that’s definitely going to happen. But you get the point…
The stage is set for a serious uptick in buying activity. Especially when we factor in slowing organic growth rates for S&P 500 companies, which puts the pressure on management to go out and “buy” growth to appease bottom-line-driven shareholders.
As I promised yesterday, here’s the safe way to play the coming takeover boom…
Be An Arbitrageur!
Although the potential for a 52% gain in a single day is ridiculously appealing, we’re dealing with hard-earned capital, here. And I understand that not everyone wants to cherry-pick a handful of takeover targets before a deal is announced… and get it wrong.
So don’t try. Instead, eliminate all the guesswork and wait until after the takeover announcements are made public.
Yes, you can make money doing that. Good money, in fact, by using a battle-tested strategy called merger arbitrage.
Even better, you can hire professionals to put the strategy to work for you by purchasing the Merger Fund (MERFX). It’s one of the longest-running (if not the longest-running) merger arbitrage funds in existence.
It naturally stands to benefit from the imminent uptick in M&A activity, as there will be more and more deals for the managers to buy.
To be fair, the managers won’t hit it out of the park. But remember, this is a conservative option. And if history is any guide, they’ll deliver steady stock market returns while taking bond market risk.
Over the last 15 years, the fund has averaged a return of 5.17%, compared to an average of 4.79% for the S&P 500 Index, according to Morningstar data.
Bottom line: The fear bubble has been busted and has all but disappeared. Even if I’m completely wrong, and it returns with a vengeance to roil the markets in 2014, the Merger Fund still represents a smart bet.
Why? Because it only had one down year in the last decade – 2008 (of course) when the fund lost 2.26%. But that sure beats the 37% drubbing the S&P 500 suffered.
Please note: Because of the high turnover in the fund (240%), it’s not very tax-efficient. So it’s best to buy it in a tax-advantaged account like an IRA.
Ahead of the tape,