Stock market investors are getting another buy signal from a vibrant mergers-and-acquisitions climate, particularly from the smaller companies that make up the backbone of the US economy.
Among the other factors working in favor of stock bulls—on top of cheap-dollar policies and respectable earnings growth—is a strong trend higher in mid-level M&A, which often serves as a forward-looking indicator for share performance.
M&A veterans say the deals that don't grab the big headlines often are more representative of underlying corporate trends and thus a better barometer of economic activity and future stock performance.
"The middle market is a shocking leading-edge indicator," says Hiter Harris, founder of Harris Williams, an investment banking firm based in Richmond, Va that closed about 70 M&A transactions in 2010. "When we had the downturn we truly did see it about nine months ahead. I do think the middle market is leading. It makes sense because it's really the essence of the economy, form business services to manufacturing to health care to technology."
Small- and mid-cap stocks are usually looked to as rally leaders, so deals in the sector are often a sign of vibrance. Some stock pros, though, dispute whether M&A is a leading indicator of stock growth, or more coincidental with rallies.
Deals worth $500 million to $1 billion for companies in the Standard & Poor's 500are about 27 percent ahead of the pace for the same period in the previous two years, according to Capital IQ.
That reflects broader trends in M&A, which on a global basis is up 28.9 percent from the previous year. US-only deals are up 85.1 percent, marking the biggest quarter for M&A in nearly four years, according to date from Mergermarket Group.
The trend lately has been lurching, with a surge at the end of 2010 in smaller deals because of firms rushing to get deals done ahead of anticipated tax hikes that
That was followed by a quiet period in the early part of 2011, but a sustained move higher now seems in place.
"There was a lull in January and February because nobody had time in the fourth quarter to really tee up their next round of sales," Harris says. "But that pipeline has gotten filled very rapidly. Our backlog is at this point over last year. We see some fundamental strength in the market and some good momentum this year."
Based on previous cycle's performance, such as in 1999, mid-tier M&A leads stock market performance by eight or nine months, he adds.
That would come as good news for investors in stocks, where a two-year rally appeared to tire during March and early April. But the past two weeks have seen the major averages hit multi-year highsas the likelihood of continued easy-money policies from the Federal Reservehave fed an across-the-board rally for the capital markets.
"It does suggest that at least some of the cash being held by US corporations is being put to work," says Brian Gendreau, chief market strategist with Financial Network, based in El Segundo, Calif. "Unless you get a rise in M&A activity it's hard to see a sustained bull market develop."
To be sure, the news isn't all good when deals are abundant.
The "M" part of the equation can cause concern because when companies merge there often is a search for synergies and duplication of resources that can lead to job cuts.
On the other hand, the "A" part, when one company takes over another so it can add to the services or products it offers—think pharmaceuticals, for instance—it can be representative of economic growth and positive credit conditions.
"For executives to have the confidence to make acquisitions they have to have a certain amount of visibility on the future," says Alec Young, equity market strategist at Standard & Poor's. "That's generally going to be more pervasive during periods of economic expansion."
The $1.4 billion bid from French oil giant Total for SunPower is an example of a smaller deal where the melding of two companies would represent expansion. The energy industry, in fact, would be a likely sector where such deals would take place as a consolidation trend takes hold.
With fuel costs soaring, energy by far has been the leading gainer of the 10 S&P sectors, rising more than 16 percent in 2011, with health care second on a nearly 12 percent jump.
"You're just not going to have the buyers unless there's some belief in the sustainability of the recovery," says Jim Paulsen, chief market strategist at Wells Capital Management in Minneapolis. "The last thing you want to do is buy a company and then see it go south."