Money managers trying to gauge the stock market’s direction have started looking to the buyout business for signals, and they don’t like what they are seeing

Aug 11, 2013

Stock Investors Take a Cue From Private Equity

By E.S. Browning

Money managers trying to gauge the stock market’s direction have started looking to the buyout business for signals, and they don’t like what they are seeing. With the Dow Jones Industrial Average up 18% this year and the Federal Reserve planning to cut back on the bond-buying it uses to stimulate markets, some investors worry that the stock market has gotten pricey and could pull back. They see evidence in the behavior of buyout firms that specialize in taking companies private. “There are a lot of people who think this is a better time to sell than to buy,” and in particular the buyout firms, said David Joy, chief market strategist at Ameriprise Financial Inc., which oversees $700 billion for its clients. When sophisticated investors pull back, some analysts believe, it is a sign that the smart money is growing skeptical on the outlook for stocks.Mr. Joy, who doesn’t commonly warn clients away from stocks, last week sent them a report noting that buyout firms see the market as frothy, making this a risky time to invest.

“Given that we have come so far, it wouldn’t surprise me if we gave up a little bit here,” Mr. Joy said in an interview.

He said it would be normal for stocks to pull back once investors conclude that the Fed is about to cut back on stimulus. While he said he expects stocks to be a good investment for the long term, he compared buying stocks today to “tiptoeing past the graveyard,” which he said people should do only if they understand the risk of a pullback.

Executives at buyout firms have made no secret of their opinion that the stock market is overpriced. They are selling record amounts of their own holdings. They are buying at a rate that is far below past highs and also well below the amount they could easily spend if they chose to.

“Based upon what I see today, I expect our investment total for 2013 to be lighter than 2012,” Carlyle Group co-founder William Conway said after releasing quarterly results last week. He said U.S. prices are so high that it is hard to find attractive investments.

Blackstone Group President Hamilton James expressed similar concerns in July after releasing his firm’s results. “With credit markets hot and equities strong, this is a better quarter for selling assets than for buying in our opinion,” he said.

So far this year, buyout firms have pulled in a record $57.8 billion by taking companies they own public or selling stock in them, according to Dealogic. That far surpassed the $35 billion in the comparable period in 2007, the pre-crisis peak, and the previous record of $43 billion in the comparable period of 2011.

The firms also have been issuing new debt at a record pace, taking additional money out of their holdings by paying themselves dividends.

And they have been less aggressive about purchases. New buyouts completed this year are running at only about one-quarter the record 2007 rate.

Investors worry about the stock outlook on other grounds as well. Those who specialize in finding stocks that are priced below their intrinsic value complain that they can’t find cheap companies to invest in. They have decided to hold more money in cash.

Others note that a measure of the S&P 500’s price compared to a 10-year average of its component companies’ earnings, maintained by Yale economist Robert Shiller, is running well above its past average.

None of this means that stocks necessarily are about to sag. It is harder for stocks to rise when they are pricey than when they are cheap, of course. But as long as the Fed is determined to intervene to support markets when they come under pressure, stocks would be likely to rebound.

As the Fed starts withdrawing the bond-buying it has used to intervene in markets, however, investors could start looking more skeptically at stocks’ prices and their prospects. When they do that, like the buyout shops and the value investors, they could find themselves paying more attention to the fact that stocks are starting to look rich.