As the following graph shows, LBOs have surged in recent years:

(Announced value of all deals, including net debt; in constant 2005 US dollars; based on the date of the announcement and the residency of the target firm.)
Source: Bank of International Settlements 2007 Annual Report

Blogger Sudden Debt points out:

In 2007 thus far, global LBO’s are running at a rate 33% higher than 2006. So, it looks as if we may easily surpass $1 trillion in LBO activity this year – assuming the current rate is maintained. Total global market capitalization was $55 trillion as of May 2007; withdrawing almost 2% of market value in one year does wonders for stock prices.

However, there is an absurdity lurking here: private equity and LBO firms are taking dozens of listed companies private, but they are going public themselves. The whole process does not make any sense at all: we are being asked to pay a premium over and above what the LBO firms paid themselves in order to end up owning the same assets. It is little wonder that their IPO’s are not faring well, so far.

Add the recent widening of credit spreads which is raising borrowing costs (e.g. the CDX High Yield index has jumped from 275 bp to 455 bp in the past 45 days) and we may already have seen the peak of the LBO activity, which translated into high takeover premiums being placed on stock markets.

The underwriters of the $20 billion of Chrysler debt — JPMorgan, Citi, Goldman Sachs, Bear Stearns and Morgan Stanley — could not sell the $12 billion portion of the deal tied directly to the Chrysler auto business. The banks have agreed to take on $10 billion of the $12 billion portion of the loans, while Cerberus and DaimlerChrysler will lend Chrysler $2 billion to complete the financing.

In Europe, Deutsche Bank is the lead arranger of the loan deal to finance KKR’s buyout of U.K.-based drugstore chain Alliance Boots. According to a Bloomberg report, it and other banks involved were unable to sell $10 billion of loans out of a total $12 billion to finance the buyout.

The black eye comes as the banks and their Wall Street rivals have belatedly sought to rein in their exposure to risky debt. According to sources in the markets, banks have cut back funding to collateralized debt obligations that buy mortgage debt, and increased their collateral requirements for lending to hedge funds.

Issuance of CLOs soared to a record $57 billion in the first half of 2007. That has since slowed to a trickle. So far this month, just $1.9 billion of CLOs have been sold, according to Standard & Poor’s Leveraged Commentary & Data.

This comes at a critical time, because banks are in the process of selling more than $200 billion of loans to investors. CLOs have been big buyers of those loans, now many of them aren’t getting sold.

Last month, the near-collapse of two hedge funds managed by Bear Stearns rattled the corporate debt market. The funds made big bets on subprime mortgage-backed securities, but also held some CLOs, which were offered for sale as the hedge funds’ assets were being liquidated. It isn’t clear if the CLOs were actually sold, but the prospect of a fire sale spooked some investors and made them reassess their appetite for riskier corporate debt.

LBOs were profitable in recent years due to low borrowing costs and strong corporate profits. With interest rates on risky debt rising, borrowing has suddenly become much more expensive for private equity firms. But the nasty surprise will come when consumer spending continues to deteriorate leading to a decline in corporate profits. That is when the LBO bubble will turn into a bust.

The Economist explains what’s behind the fear of a liquidity contraction that shook the markets today:

Calling it a credit crunch might be an overstatement. But it does look like a credit squeeze. In recent years, investors’ enthusiasm for high-yield products has allowed borrowers free rein in the debt markets. Blessed by strong profits and buoyant economic conditions, companies seemed more than capable of paying back their debts; default rates have been remarkably low.

Indeed, such was the power of borrowers, private-equity groups chief among them, that they were able to dispense with the market’s traditional safeguards. They dropped some of the covenants that gave lenders the right to act if the borrower’s finances deteriorated.

Suddenly, however, investors are turning their noses up at some deals. Banks that had lent large sums to finance the buy-out of Chrysler, the car giant, and AllianceBoots, the drugs retailer, had hoped to sell these loans to an eager market. This week both debt sales were postponed in the face of sniffy investors. A similar sale to fund the buy-out of US Foodservice, a food distributor, was scrapped last month. Even before the latest news Baring Asset Management counted 28 corporate-bond or loan deals, worth around $17 billion, that had been pulled since June 22nd.

What has prompted this change of heart? Many point to the problems in the American subprime-mortgage market, where defaults have risen and several hedge funds have been wiped out in the process. Countrywide, a mortgage bank, has triggered further concerns by admitting that bad-debt problems are now spreading to conventional loans.

When investors suffer losses in one part of their portfolio they get nervous about potential problems elsewhere. On July 20th the European crossover index, which covers riskier corporate debt, suffered the worst day in its short history. The spread (excess interest rate) over government bonds widened by two-fifths of a percentage point.

Investors may also be suffering from indigestion. According to Moody’s, a rating agency, nearly $1 trillion was raised in European credit markets in the first half of the year. Greg Peters, a Morgan Stanley strategist, says that $57 billion of bonds and more than $200 billion of loans are already in the pipeline: a plentiful supply of debt to absorb the potential demand.

It is hardly surprising, therefore, that investors have decided that higher yields are needed. This has caused a temporary hiatus as issuers get used to the new regime. But it looks more like a return to normality than a buyers’ strike. Credit-default swaps (which insure investors against a failure to repay) reflect this shift in sentiment. Jim Reid, the credit strategist at Deutsche Bank, says swap spreads in the European high-yield market are now wide enough to compensate for the average historic default rate. In America spreads are well above that level.

Pushing spreads further might require some actual defaults. That, in turn, would probably require the global economy to weaken significantly. At the moment, however, economists seem pretty sanguine, forecasting output growth of 2.7% for America in 2008 and 2.3% for both the euro area and Japan.

A benign view of the economic outlook may be why the Dow Jones industrial Average recently passed the 14,000 level for the first time. But stockmarkets have shown signs of concern at developments in the credit markets; their latest wobble was on July 24th.

Some of the fundamental supports for equities are being eroded. In America, corporate profits are on course to grow by 5.5% in the year to the second quarter, a long way below the double-digit rises to which investors have grown accustomed. The proportion of firms beating expectations in the second quarter was at its lowest since late 2002. By the measure derived from America’s national accounts, profits fell in the fourth quarter of 2006.

And the takeover boom may be near its peak. “The tide appears to be going out for leveraged equity financiers,” says Bill Gross of the bond giant Pimco. Bids have become more expensive to finance while share prices have been rising. Citigroup says that, in mid-2005, the corporate-bond yield was 4.4% and the trailing earnings yield on European equities was 6.8%. That made it highly attractive to issue debt to buy shares. But by mid-July the bond yield was 6.1% and the earnings yield 6.3%, a much less attractive trade.

Predators can be inventive in finding sources of finance for their deals, as Barclays has shown. At the margin, however, bids are becoming harder to pull off. The banks are now stuck with the risk of the AllianceBoots and Chrysler deals. They won’t want to make that mistake again.

I am betting that this is just the beginning of a substantial rise in risk premiums.

The New York Times points out that as painful as Tuesday’s 3.3% plunge in the DJIA was, “you could almost call that a blip when measured against the biggest plunges on record.”

My gut tells me that we will get at least one more day this year that will surpass Tuesday’s drop.

I just came across a fascinating article from Hussman Funds that clearly explains why investors should be concerned with corporate America’s record profit margins. The bottom line is it won’t last — and when it begins to contract, equity valuations will fall too.

Last July ProFunds released an interesting ETF product, called ProShares, which can provide double the inverse performance of some of the major indices. These are in addition to several other ProShares leveraged offerings:

There already exists a few open ended mutual funds from ProFunds and Rydex that do the same thing, but they come with expense ratios of around 1.5% compared to only 0.95% for the ProShares.

As a bear I was attracted to the double inverse ProShares since they can be held within retirement accounts. I would also be interested in holding them in my non-retirement accounts if they offered more leverage than shorting. Due to the margin requirements of my broker I am required to have 130% of the value of a short position of any option eligible securities. Buying ProShares, on the other hand, requires margin of 50%.

To use the UltraShort S&P 500 (AMEX:SDS) as an example, every $100 of margin in my account allows me to hold $200 of the SDS (or $200 of double the inverse of the S&P 500). If I were to short $200 of the S&P 500 in the traditional sense through the Standard & Poor’s Depository Recipts (AMEX:SPY), I would need only $60.

Now let’s say the S&P 500 declined by 10% after 1 year. Then my $200 holdings of SDS will gain by 20% or $40. Since I invested only $100 my return would be 40%. On the other hand, my $100 would allow me to short a maximum of $333.33 of SPY. Since the S&P 500 fell be 10% the SPY will fall by 10% too. Under this scenario I would gain $33.33 or 33.33%.

Of course leverage can work both ways: if instead the S&P 500 had increased by 10% I would have lost 40% through buying the SDS compared to only a 33.33% loss by shorting the SPY.

There are some other costs associated with holding the UltraShort ETF’s that were not factored in this analysis. First, buying with margin entails interest expenses on the loan amount. In my case, currently my broker charges 6% annually. Second, there is an expense ratio of 0.95% for all ProShares. And third, the funds employ swaps which can have negative tax consequences.

As good as these ETFs are, they are not superior to shorting or even futures which can offer much more leverage. These products are better suited for accounts that are unable to short like retirement accounts.

I currently own the SDS and the UltraShort MidCap 400 (AMEX:MZZ) in my retirement accounts.

I found some excerpts of an interview that BusinessWeek conducted with CNBC’s star personality Jim Cramer. When asked about his outlook for 2007, he doesn’t hide his bullishness:

I think it’s going to be real good… We have incredibly low interest rates. Forget the big mortgage problem. The big story for 2007 is that we just don’t have enough stock. Twenty-nine of the 30 stocks in the Dow Jones average have buybacks. If you take a look at the moves you see in stocks now, it’s because there are just no sellers… Then layer on the fact that the private equity guys have just raised $3 trillion… Those forces are all fabulous for the market.

Now I’m no fan of Cramer’s but I thought I would simply make a note of it so that 12 months from now we can look back and see if he’s right.

Cramer’s a sharp, charismatic and hard working individual but that doesn’t necessarily make someone a great investor. He always prefers to go long on stocks. When stock prices decline, he simply increases his position betting that the market is merely experiencing a correction. This strategy works well during bull markets. Not surprisingly he came to prominence as a successful hedge fund manager during the eighties and nineties — a period when stocks were on a spectacular bull run. During a bear market his strategy could cause him to underperform the market.

I think difficult times are ahead for the stock market — and Jim Cramer’s popularity.

In the last post of this series, The Coming Bear, I discussed the reasons why I believed the economy was headed for a housing-led recession in 2007. If this turns out to be correct the stock market is going to fall dramatically and will probably challenge the 2002 lows.

Even if I am wrong and the economy continues to grow at its current pace with corporate earnings rising along with it, the stock market is overvalued by almost every measure:

• P/E ratios are well above the historical average of about 15. Typically the beginning of a bull market is signaled when P/E ratios fall below 10. Currently, the S&P has a P/E ratio over 18.
• The Dow/Gold ratio currently trades at 19. This ratio has equaled 1 a few times in the past which made for a great time to buy the Dow and sell gold. Right now gold is the better buy.
• The Dow dividend yield stands at 2.17% which is less than half of the yield on the 10-year treasury. Many times in the past Dow stocks were yielding over 5%

For these reasons it is very hard to imagine that stocks will produce above average returns in the future. Now if I am correct and the economy does suffer a housing-led recession and earnings do fall, then we could see stock prices get hit very hard.

Almost all sectors of the stock market should be negatively affected including retailers, technology, transports, financials, commodities, and of course real estate. Only gold stocks will be spared since their performance depends not on economic growth, but on monetary and foreign exchange conditions.

If you really want to protect yourself from the coming bear market, the best strategy is to sell all of your stocks. Now this may sound heretical to you since you have always heard that stocks are the best performing asset class over the long term. But this depends on what is defined to be long term.

Consider that from 1968 to 1979 the best performing asset was gold which increased 19.4% annually. Stocks on the other hand gained only 3.1%. If you owned stocks during this period you actually lost money since inflation was running at 6.5%.

I am not sure how you feel, but I feel 10 years is a long time and I would hate to lose my money over so many years. So it is possible stocks can perform very badly for a long time. As discussed in this series of posts I believe we are in such a period. The bear market began in 2000 and should last for around 10 years. If you want to preserve your investments for the rest of this decade do the most logical thing… sell your stocks!