When the credit markets froze solid last year, equities hit the skids, the economy tanked and so did the number of announced mergers and acquisitions (M&A).

But now the stock market’s on the mend. In my book, a 49% rally off the bottom for the S&P 500 qualifies as healing.

The economy’s showing signs of improvement. First-time jobless claims have dropped more than 15% since peaking in April.

As for the M&A market, well, it’s still suffering…

Through the second quarter, volume dropped 40.2% worldwide. Deals involving U.S. companies fared worse, dropping 57.5%, according to Thomson Reuters. And July marked the first month in over a decade when not a single deal worth $5 billion or more was announced.

But if you’re serious about investing, you need to know when the M&A market is on the upswing and should be tracking it religiously.

Why?

Because nothing causes stock prices to rise faster and further than an unsolicited takeover offer.

In fact, if we invest in a company before a deal is announced, we stand to pocket an average gain of 43.5% to 53.7%, according to the numbers crunchers at FactSet MergerStat. In a single day! No other investment strategy can boast the same lightning fast rewards.

Tracking M&A Market Activity With High Credit Spreads

If you’re looking for one number to predict a full-blown rebound in M&A market activity – and signal the best time to invest in takeover targets – try high-yield credit spreads. The spread is simply the difference in interest rates between junk bonds (the typical vehicle used to finance M&A) and comparable U.S. Treasuries.

• When the spread is high – above the historical average of 590 basis points – it means banks consider the risk of lending to suitors to be above average. In turn, they compensate for the higher risk by charging higher interest rates, thereby choking off M&A market activity by making financing too expensive.
• On other hand, when the spread is below the historical average, it means banks consider the risk of lending to be low. In turn, they charge lower interest rates, which encourages M&A activity as companies capitalize on the cheap financing to go on buying sprees.

Right now the spread stands at 857 basis points. At first blush that seems terrible, until you look at this chart.

http://www.investmentu.com/images/iu081209chart.gif

Following the collapse of Lehman Brothers, spreads hit a high of 2,180 basis points! So we’re actually down 61% from that level, with momentum squarely on our side.

As this trend continues, financing will become more affordable. In turn, I expect M&A market activity to come roaring back.

The markets remained littered with historic values. More importantly, there’s a mountain of cash waiting to be leveraged and put to work.

Private equity funds alone are sitting on $1.02 trillion in dry powder, according to London-based research house Preqin. Almost half of that – $472 billion – resides in buyout funds. If they don’t find it a home (i.e. – start buying companies), they’ll be forced to return it to investors.

How to Play The Imminent M&A Market Rebound

In previous columns on the takeover boom, I explained my strategy for uncovering the market’s most promising takeover targets and highlighted sectors and companies ripe for the picking.

However, if you’re looking for a more conservative way to play the imminent M&A market rebound, and the acquisitive nature of private equity funds, consider The Blackstone Group (NYSE: BX).

Here’s why…

• Private equity firms typically enjoy the best returns from investments made in a down market. And Blackstone’s sitting on a $26 billion cash pile to take advantage of all the bargains and practice its expertise in distressed investing, deal making and restructuring.
• Sure, other options exist to get exposure to the private equity space and the M&A market, namely Fortress Investment Group, LLC (NYSE: FIG) and Och-Ziff Capital Management Group (NYSE: OZM). But neither stack up to Blackstone in terms of experience, expertise or financial resources.
• Plus, by investing in Blackstone you get a portfolio of companies that are much healthier than the market. Roughly two-thirds of the companies will report positive or flat earnings, compared to just 35% for the S&P 500. And almost no debt is coming due until 2013, eliminating the refinancing risk plaguing countless other businesses.

Tack on an annual stock dividend of $1.20 (equivalent to an 8.4% yield) and this is a no brainer. You’ll get paid to wait for the M&A activity to rebound and the Buyout King to get back to buying.

Good investing,

Louis Basenese
Investment U