How to profit from merger mania

It took only a 48-hour period recently to rack up more than $60 billion dollars through buyouts and mergers.

That's a lot of scratch.

In fact, that's more money than the total Gross Domestic Product (GDP) of 70% of the 181 countries that are members of the International Monetary Fund.

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Indeed, Borat's own resource-rich Kazakhstan had a GDP of 'only' $56 billion in 2005.

With so many companies getting bought and sold in a very short time, what does that mean for us as traders and investors? Plenty - including the fact that stock prices are racing higher, and investors are doing almost anything to chase higher yields.

Let's look at the drivers for this recent spending spree and what we can do not only to protect ourselves, but profit, too.

What's driving the M&A boom?

In the leveraged buyout boom of the late 1980s, the driver was massive amounts of debt (in the form of high-yield or 'junk' bonds).

In 1999 and 2000, the bulk of merger and acquisition (M&A) activity was largely driven using tech companies own money - in the form of over-inflated stock shares.

But the 2006 M&A feeding frenzy features the best of both worlds. Stock prices are currently soaring, with the Dow at all-time highs and the broader indexes at multi-year highs. This gives companies high book values and financial leverage.

But the even bigger driver for this current round of buyouts is a chase for yields that would make former junk bond king Michael Milken proud.

There are really only two ways to buy something - using money you've made or money you've borrowed. And companies are borrowing money like never before.

The Wall Street Journal reports that at least two companies have made their buyouts with so-called 'toggle' bonds - a type of bond that is every bit as risky as it sounds. They allow companies to borrow money on the premise that they can repay the debt either with company cash flow (the old fashioned way) or by issuing more bonds (the new fangled leverage-to-the-hilt way).

And the Wall Street Journal reported today that the value of leveraged buyouts in 2006 has already eclipsed total M&A value of 2000. All of the sudden, the current round of M&A activity starts to sound like a mania.

How to protect yourself - and profit

When companies start buying others at a clip that outpaces the most torrid in history, we should take notice. And when they do it using leveraged borrowing strategies that would make even the most jaded home lender blush, I want to make sure I have a tight grip on my wallet - and my portfolio.

Here are a few things you can do to protect yourself - and even profit - from the current frenzy:

1. Be Very Careful Looking For a Top: If you think things are getting a bit too heated up and that the market has to correct down, I'm with you. BUT... don't get too excited about selling positions or jumping on the short side just yet. The lessons of past tops show us that the market can remain overheated (and even overbought) for a long time. There are some good cycle analysis reasons to look for a reversal in the next few days. However, you need some significant price moves off of these tops to trigger any portfolio rebalancing.

2. Remember: Price Moves Are Over-Exaggerated At Stretch Points: I wouldn't be at all surprised to see a blow-off top during this current move. The market has enjoyed consistent strength for six weeks... M&A activated is reaching a fever pitch... and retail investors may still get to frenzied participation. When things heat up like this, we can reasonably expect to see some wild moves - both up and down - before the market decides whether it will continue its march upward or take a plunge.

3. Don't Over-Indulge In High-Yield Instruments: Having some exposure to high-yield instruments (a.k.a. junk bonds) is a good practice - especially when there is so much capacity in the market at present. HOWEVER... remember that things ended badly, and suddenly, when the bottom dropped out of the junk bond market at the end of boom in the 1980s. Moderation is the key word here - don't stay overexposed in this area.

4. Keep An Eye On Investment Banks: Who consistently has the most to gain when M&A activity is hot? The answer is the investment banks that broker deals, handle due diligence, etc. So keep an eye on Goldman Sachs, Lehman, JP Morgan Chase and the other top players - because trouble in the M&A world will be quickly reflected in their share prices. Until then, look for their prices to continue strengthening.

Frothy M&A activity is a both a result of strong markets - and an early indicator of over-extension. But make sure you look for confirmation from technical indicators and other market activity before deciding that the market has topped out.

By D.R Barton Jnr, Quantitative Analyst, Mt. Vernon Research for the Smart Options Report, www.smartoptionsreport.com