Short sellers cheered Wall Street's steep stumble, but the best news they had in recent days was that buyout mania could soon be ending.
Carlyle Group head David Rubenstein a leader from the private-equity world said the top of the record-setting buyout cycle could be near. We can't continue like this forever, he said during a conference.
Since the acquisition frenzy has helped push stocks higher over the last year, his words has to please short sellers, investors who sell stock on a bet they can make money by buying shares back later at lower prices. It also should scare anyone else who hopes for a continuing market rally.
With big companies out in force buying smaller ones and buyout firms taking public companies private, investors have been piling into stocks they believe could be potential takeover targets even ones with faltering fundamentals whose share prices arguably should be falling.
That has been a nightmare for many short sellers. When prices rise they have to cover their shorts by buying shares at higher price. That means even though they generally are the most bearish about the market's prospects, their short covering ironically has helped to fuel the record gains on Wall Street in recent months.
But the shorts got some reprieve over the last few days. First, stocks tanked on Tuesday in the largest sell-off since the market reopened after the Sept. 11 terrorist attacks more than five years ago. Shares then seesawed in the subsequent days with moderate gains and losses.
While that doesn't mean stocks have been thrust into a full-fledged correction, it certainly exposed some weakness in the market for the first time in eight months.
That helped some short positions. For instance, at American Airlines' parent AMR Corp., total short interest has dropped in half over the last year amid speculation of consolidation in the industry. Aggressive purchasing by shorts had been driving AMR's shares higher until the recent market pullback, according to ShortSqueeze.com, which tracks short interest data.
More important, however, was the warning from Carlyle's Rubenstein on Wednesday that private-equity firms need to prepare investors for the end to the buyout bonanza. His comments carry weight in financial markets given that Carlyle, with nearly $50 billion under management, is one of the biggest and most active of the buyout firms.
The buyout-friendly environment of cheap and plentiful debt financing as well as hoards of cash on corporate books has yet to disappear. But Rubenstein warned that an inevitable downturn could come from a variety of catalysts, such as an economic slowdown, tightening of credit by the Federal Reserve or a legislative or regulatory change.
Decline and losses will occur, he said in comments to the 10th annual Super Return private equity and venture capital conference in Frankfurt, Germany.
The short sellers, however, might have to be patient before such a change actually comes. The dealmaking boom set records in 2006 with $4.023 trillion worth of mergers and acquisitions and continues on a blistering pace this year, with $634 billion in deals so far, up from $572 billion in the same period a year ago, according to Dealogic.
In recent days, electricity producer TXU Corp. agreed to be acquired by a group of private-equity firms for about $32 billion in what would be the largest private buyout in U.S. corporate history. Also, casino-owner Station Casinos Inc. announced it would be acquired by Fertitta Colony Partners LLC for about $5.4 billion, while business software maker Oracle Corp. will buy Hyperion Solutions Corp. for $3.3 billion in cash.
Also, the recent stock pullback doesn't mean the shorts suddenly have the upper hand. As Citigroup Inc.'s chief U.S. market strategist Tobias Levkovich points out, in the 43 instances since 1962 that the Standard & Poor's 500 index has fallen 3 percent or more in one day as it did on Tuesday it has rebounded to an average gain of 2.64 percent within 20 days and 6.02 percent within two months.
One needs to think deeply about trying to short the market now as indices are already down, particularly when the underlying fundamentals we track have not collapsed in any meaningful way, Levkovich said in a note to clients Wednesday.
Still, the tide seems to be turning a bit for short-sellers. Investors pulling for stock gains better beware.