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The Economy Looks Great -- Just Ask the Credit Markets

Credit-market confidence, mergers and acquisitions, and a steadily improving economy

by 9/11/2012 1:15:12 PM
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Well, it's safe to say second-quarter earnings came and went, and overall, they were a disappointment. In fact, revenue numbers were very disappointing across the board. Companies have cut a lot and eventually they'll need to have some organic growth to prove their worth. Now the big question becomes, if earnings season was such a disappointment, how in the world are we be breaking out to new highs?

There are two reasons. First off, sentiment continues to be extremely low, which lowers overall expectations. Here's a little secret -- bad news isn't bad if the expectations were for horrible news. The other reason we are rallying is that the credit markets remain very strong. If I had to pick one area of the economy that actually matters to how stocks might do, it'd be the credit markets. As funny as it sounds, earnings are important, but not important as the credit markets.

Back in early July, I said the credit markets looked great and should lead to higher stock prices. That's easy to see now, but back in July there was a serious end-of-the-world vibe from a lot of very smart people. Of course, those people ignored what the credit markets were telling us. Near-term history tells us that the credit markets stopped working before the market cracked in late 2008, and started firing on all cylinders right as the stock market began to bottom in March 2009. Looking at things now, I continue to see signs the credit markets are still improving, and this bodes well for both the economy and stock market through the end of the year.

First off, banks are lending as much as they did right before the financial crisis. This shows that confidence is slowly coming back. Also, the little-followed Fed survey of senior loan offices has shown that credit conditions have increased for three straight quarters. I'm guessing the average investor had no clue on that one. Given that credit markets tend to lead the economy by six to nine months, I find this to be rather encouraging.

Mergers are another sign of an improving credit market. When it's easier to get financing, it's easier for deals to happen. At the same time, companies aren't going to make deals if they aren't optimistic about the future. They'll just hoard cash.

Over the past few months we've seen a good deal of transactions occurring. Again, this is all about confidence and is another great sign. Here's a sample of some of the deals that have transpired during the past two months:

  • WellPoint, Inc. (NYSE:WLP) bought AMERIGROUP Corporation (NYSE:AGP) for a 40% premium.
  • Best Buy Co., Inc.'s (NYSE:BBY) owner is tried to take the company private at a nice premium.
  • FX Alliance Inc (PINK:FXAI) bought Thomson Reuters Corporation (USA) (NYSE:TRI) at a 40% premium.
  • Chicago Bridge & Iron Company N.V. (NYSE:CBI) purchased The Shaw Group Inc. (NYSE:SHAW) at a 70% premium.
  • The Home Depot, Inc. (NYSE:HD) acquired US Home Systems Inc (NASDAQ:USHS) at a 40% premium.
  • Aetna Inc. (NYSE:AET) bought Coventry Health Care, Inc. (NYSE:CVH) at a 20% premium.
  • Hertz Global Holdings, Inc. (NYSE:HTZ) acquired Dollar Thrifty Automotive Group, Inc. (NYSE:DTG) for a 7% premium.
  • International Business Machines Corp. (NYSE:IBM) purchased Kenexa Corporation (NYSE:KNXA) for a 43% premium.
  • Vertex Pharmaceuticals Incorporated (NASDAQ:VRTX) bought Medicis Pharmaceutical Corp (NYSE:MRX) for a 40%.
  • Fifth Third Bancorp (NASDAQ:FITB) sold $4.4 billion in assets to Federated and Touchstone Investments.

Say what you want, but that's a lot of big-time deals getting done for some major premiums over what the market thought those companies were worth. Again, it's all about supply and demand. If a company gets bought out, it's bullish for the overall market. This means there is less supply. Yet, if demand stays the same, then prices should rise.

Lastly, the action in junk bonds (or high yield bonds) is simply great. Remember, junk bonds tend to act like stocks, and when investors are comfortable with the economy, they are willing to buy the riskiest of bonds. Why would you buy risky bonds if you think the company paying would just default? With that said, various junk bonds are breaking out to new highs. For me, this confirms the new highs in the stock market and bodes well for continued strength into the end of the year.

Chart of SPDR Barclays Capital High Yield Bond ETF (JNK) since September 2011
Chart courtesy of StockCharts.com
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