For background information about methodology and definitions, please click here.
Market Overview
After some profit taking in January that erased much of the gains from 2004, the capital markets have bounced right back in recent weeks. The S&P 500 is down only slightly at 1210.34, which is still close to its 3 ½-year high of 1213.55, reached on December 30th. The NASDAQ remains down 4.05%, but the Dow Industrials are up 0.5% as of mid-February, within 20 points of the 3 ½ year high set December 28th. Small-cap stocks, which outperformed the broader market in 2004, have continued to improve. The S&P SmallCap 600 Index hit a record high of 330.69 on February 8th, and the Russell 2000 was up 4% for the week ending February 4th.
The first 45 days of 2005 have so far demonstrated a continuation of the market's stability over the past 12 months, but increased volatility may be ahead. In 2004 there was only a 14.1% spread between the high and low points on the S&P 500, compared to 38.9% in 2003 and a historical average spread of 33.8% since 1928. Although we agree with analyst projections for overall GDP growth of 3.75% to 4.00% this year, uncertainty about employment, the federal trade deficit, an ongoing war in Iraq, and social security reform could still lead to greater volatility in the capital markets.
The Federal Reserve met on February 2nd and raised the federal funds rate by 25 basis points to 2.5%, and is expected to continue "measured increases" throughout 2005. Most analysts see an end to fiscal tightening by the second half, as futures contracts imply that the central bank will increase rates no higher than 3% by year end.
Merger Activity
Following a flurry of big deals at the end of 2004, M&A activity is off to a strong start, with over $144 billion of deal volume in the first 40 days of 2005, which Thomson Financial indicates is the fastest start since 2000. So far the mega deals of 2005 have been largely about market share rather than expansion into new product lines. These transactions include Procter & Gamble's announcement to acquire Massachusetts-based Gillette, and SBC's planned acquisition of AT&T.
It's worth pointing out that the more recent large transactions have involved more prudent strategies than were common in the frothy years of 1998-2001, where mergers destroyed approximately $134 billion of shareholder wealth, according to a study by Rene Stulz of Ohio State University. One reason is increased restraint. Premiums on recent transactions such as the Gillette bid, have come down to 15 to 20%, which is just half the premium that many tech companies were paying during the boom. Corporate boards have realized that it's hard to improve shareholder value when they overpay for an acquisition, which is one of the key reasons for Carly Fiorina's recent departure from HP. The more reasonable valuations are expected to lead to increased buy-out activity in 2005, as demonstrated by the Feb 11th offer by Highfields Capital (a $6.5 billion Boston hedge fund), to acquire Circuit City in a proposed $3.2 B take-private transaction. The $17.00 per share offer was just below a 20% premium.
