One Troubling Sign of a Market Top - Beware of the Buyout

Sure, it seems like this stock market can continue to gradually move higher indefinitely. But investors looking for warning signs have gotten a big one in recent weeks. It’s a sign that’s popped up before in the markets that has signaled some poor performance ahead.

Sometimes it’s come ahead of big crashes, sometimes it’s come ahead of a year or two of significant underperformance. But whatever happens in the future, it’s a warning that’s happening now.

The sign is a simple one: A record-setting buyout offer. While companies merge all the time, it’s when the level is record-setting that proves a sign of a potential top. That’s because big mergers are a sign of confidence in the economy, and typically occur only well after the economy has been expanding for a long time.

The specific offer this year has come from private equity firm KKR, with an offer to buy up drugstore chain Walgreens Boots Alliance. Given the margins involved in a chain of physical stores, and the record-setting price if the deal goes through, it’s a definite warning for market underperformance ahead.

KKR plans to take on substantial debt to make the buy, and then improve the company’s business to make the payments on that debt. This process is known as a leveraged buyout, or LBO. While that sounds good now, years after the economy has been expanding, a slowing economy could slow those cash flows and make repayment difficult.

Previous record-setting deals that sounded great on paper, like the AOL-Time Warner Merger in 2000 or the RJR-Nabisco merger in the late 1980’s, likewise proved more problematic in reality than in theory. That’s why there’s a big warning sign for investors now that market performance may stall out in the next year. It may not always mean a big crash is ahead, but even a slowdown may lead to a change in how you want to invest.

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