THE DOW JONES industrial average closed above 14,000 for the first time Thursday, a historic, if puzzling, milestone.
Most finance experts agree that stock markets thrive during periods of steady economic growth and political stability. But today's economy hardly is clicking on all cylinders, and the geopolitical landscape has never seemed more perilous. So what's driving this market to such heights? In a word: takeovers.
Wall Street is in the midst of a raging leveraged buyout boom that makes the "greed-is-good" 1980s look like the Great Depression. Leveraged buyouts are Wall Street's version of "Flip This House": Borrow a bunch of cash to buy a company, dress it up by scrubbing the books and streamlining the operation, and resell it all for a tidy profit.
In the second quarter of 2007, companies around the world bought and sold an unprecedented $1.65 trillion worth of businesses, 90% more than during the same three-month period of 2006. At this pace, global corporations should easily surpass the previous annual merger record of $3.6 trillion worth of deals, which was set just last year. The market has gotten so crazy that notoriously secretive buyout partnerships such as Blackstone Group and Kohlberg Kravis Roberts & Co. actually are cashing in by going public.
The fuel for all this buying and selling is cheap debt supplied by major banks and lenders. Desperate for a seat at the lucrative takeover table, they're willingly handing out gobs of money, with practically no strings attached, to anyone even contemplating a buyout.
As a result, the market is rife with stock speculation, because practically every company is a potential takeover target. Just ask Dow Jones & Co., which essentially is being forced into a deal by an overwhelmingly generous unsolicited bid from Rupert Murdoch's News Corp. The merger guessing game has pushed countless stocks to all-time highs and is propping up most major indexes. Indeed, beyond the Dow, which already has gained 12% in 2007, the S&P 500 index is up nearly 10% and the Nasdaq composite index is up more than 12%.
A rising stock market in and of itself isn't a problem, but this is all playing out as a classic financial bubble, which means we'll probably have quite a mess to clean up when it eventually pops. In case you need a refresher on bubbles, just consider what happened in 2000 when Internet stocks came crashing down to reality and a series of corporate corruption scandals began to emerge.
But to truly get a sense of what to expect, you have to go back a little further in time, to 1989, when our last real buyout bubble burst.
Takeovers became a big story in the 1980s because, much like now, cash was cheap and readily available. Then much of the money came from junk bond king Michael Milken, at the now-defunct investment bank Drexel Burnham Lambert, who eagerly backed swashbuckling corporate raiders and buyout partnerships like KKR in larger and larger deals. As is the case today, at the time it seemed like any publicly traded company could be a sitting duck for lurking predators. And this rampant speculation helped push the stock market to record levels.
But in typical Wall Street fashion, the good times ended with an orgy of greed and overreaching. By the time Milken and KKR orchestrated their infamous $25-billion buyout of RJR Nabisco in November 1988, the merger market already was beginning to dry up. Soon regulators were zeroing in on Milken, intent on breaking his junk bond monopoly and threatening to take a closer look at all these takeovers.
In June 1989, as prosecutors circled, Milken resigned from Drexel Burnham, sending the junk bond market he created into a tailspin. And with that, the buyout bubble collapsed, eventually taking the entire stock market down with it. For perspective, consider that at the height of the 1980s merger mania, between 1985 and 1989, the Dow gained roughly 130%. But in 1990 it lost 4%.
So that's what we're up against — and it's the reason everyone cheering the stock market's historic climb might want to keep the champagne on ice for now. Because if history is any guide, this party could turn ugly.