Are we seeing the behaviours of an imminent correction?

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It’s been a great time to run a business, particularly one listed on the Australian Stock Exchange. A strong domestic and overseas economy, accommodative interest rates, easy access to capital, stable input costs and confident businesses and consumers have a gone a long way to fuelling the bull run our market has experienced.

But now, things feel different. The vibe has changed in the investing air. It’s akin to enjoying a nice summers day, when you experience a wind shift, you smell the petrichor of oncoming rain and suddenly the temperature changes.

But things have not yet turned disastrous. At the time of writing, the All Ordinaries has fallen close to 7.5% from the recent high on 30 August, with more to come it seems. Hardly panic stations yet with eight pullbacks of greater magnitude in the past five years, including a 19% drop from April 2015 to February 2016, which was the second largest experienced since the GFC. While the reasons for that pullback have long been forgotten by many investors, the sense of imminent doom was the same.

So today we read the headlines surrounding rising global interest rates, looming trade wars, impending property market implosion, tighter government controls, rising energy prices and lofty personal, corporate and government debt levels as reasons for an imminent correction. History tells us that the behaviour of the market and businesses within it may give us clues  as to whether we need to be extra vigilant. There is another signal that was present in other recent corrections, that is prominent now and should make investors cautious.

Increased merger and acquisition activity a sign that things are ‘frothy?’.

We have seen a spike in the number of private equity firms and companies buying out others. Recent bids for APA, Westconnex, Life Healthcare, Scottish Pacific, MYOB, Navitas, Asia Pacific Data Centres, and the yet to be clarified offer for Greencross, show that deals are preparing to be done. As reported by the AFR, a recent report for Dealogic shows that AUD$124 billion worth of deals have already been negotiated this year. For the first three quarters of this year, global deals announced are tracking at $US3.1 trillion, the highest level since the same time in 2007. Spikes also occurred in 2000 and 2015, followed by corrections. Only time will tell whether this bodes as a warning. When cash is cheap, and projections are high, it’s not unusual to see this type of ‘bubbly’ behaviour as a sign of overheating and a risk to the future direction of the market.

Why do executives buy companies when prices have been running hot? Often the companies that are bought are unloved laggards whose share price represents value because it has underperformed, inevitably due to poor corporate performance. Also, with many companies awash with cash, and organic growth opportunities starting to dry up, many are taking the ‘opportunity’ to acquire something to keep the growth in earnings momentum continuing. For example, the mining sector has seen companies buy other miners to replenish reserves and keep their cash at work. We also see a number of mega-mergers at this time where companies come together in a populate or perish type of attitude. Fairfax-Nine and TPG-Vodafone are two recent examples that come to mind. However often the merging of equals creates its own problems, and it can take years, if ever, for issues to be resolved.

So could now be the start of something more sinister? Of course, no one knows what will happen. But the fact is that every week brings us closer to an eventual correction. While a mild correction would be preferred over a significant crash, we don’t get the right to choose when and why a pullback occurs.

What is therefore more important to understand is why these shifts are occurring and assess the potential impact on our portfolios. While jumping at shadows is not a successful strategy to employ, being alert of active risks and managing our portfolio in a prudent manner certainly is. Don’t try to pick changing cycles before they occur, rather formulate a strategy built around your investment objectives and the level of risk you are willing to take. With risks currently heightened you need to manage your money in a way which is respectful of such times.

Chart: Bubbly activity – M&A highest level year to date since pre-GFC

Source: Dealogic

Published Tuesday, 16 October 2018 | Financial Review

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