There was a crucial difference in how most of those 1990s mergers as well as the late-1960s and 1920s deals were structured compared to the post-2002 deals. The bulk of corporate mergers taking place in 2003, 2004, 2005, and 2006 were mostly transacted in cash, whereas those done in those three earlier periods were transacted mainly in stock. In the one, an acquirer pays earnest money for the shares of the acquiree; in the other, the acquirer simply issues newly created shares to fund the takeover. Question Two: Is there a difference between the two and their potential impact on the stock market? What can you see differently about this situation others don't see? What can you fathom that is unfathomable to most?

When Company A buys Company B for cash, it exchanges the cash for Company B's shares and then simply destroys those shares. After the deal, there are the same number of Company A's shares as before the deal and no shares for Company B. Company A now has its earnings and Company B's earnings so Company A's earnings per share rise. Very simple! This assumes on an annual basis Company B is profitable and its earnings exceed the interest payments Company A pays to borrow the money to buy Company B. But otherwise, the acquisition is immediately accretive to earnings—shares are destroyed and, all else being equal, the acquirer's earnings per share rise immediately. The supply of equity outstanding in this case is reduced as the acquired company's stock is destroyed. Let me say that again. Cash-based acquisitions reduce the supply of equity outstanding. If demand remains constant and supply shrinks, prices will rise. Cash-based acquisitions tend to be bullish.

Takeovers transacted wholly in stock are different. Afterwards, usually the acquirer's earnings per share fall because more shares are dumped on the market, diluting value. See it this way. Firm A is worth X. Firm B is worth Y. To acquire Firm B, Firm A must bid up B's price. Perhaps Firm A bids Firm B up by 25 percent to 1.25Y. That extra 25 percent is paid for by increasing the supply of stock of Firm A—newly created, never before existing shares. Firm A issues enough new shares to cover all of the prior value of Firm B plus enough newly created shares to cover the 25 percent markup. So, there are more real share equivalents after the deal than before. Now, if Firm B has a higher P/E than Firm A at 1.25Y, Firm A's earnings per share fall when the deal is done. This is most of the deals in the 1920s, late-i96os, and 1990s. It is the AOL Times Warner deal. These increase supply of equity, are dilutive, and make earnings per share fall.

There is a third type of deal—Firm A buys Firm B partly for cash and partly for newly created shares. Hybrids deals are common, having some of the qualities of both but usually are more cash-like than a pure equity deal. Why? In these deals, usually the acquirer can't borrow enough cash to take over all of Company B, so it borrows what it can and issues shares to make up the difference. Usually, these are bigger deals.

Suppose Firm A is worth $10 billion and B is worth $20 billion. A buys B. The smaller A swallowing the bigger B may frighten lenders. Maybe lenders will only lend Firm A $14 billion to buy B—exactly why doesn't matter for this example. Before the deal there were $30 billion of equities outstanding representing A and B together ($10 + $20 = $30). To buy Firm B, Firm A bids B up 20 percent to be worth $24 billion. It uses the $14 billion it borrowed and issues another $10 billion of its own newly created shares to total the $24 billion it needs. At the end of the deal, there are $20 billion of equities—down from $30 billion before the deal. The supply of equity shrank by $10 billion—not by as much as if they'd financed the whole thing with debt—but the equity supply shrank nonetheless. Almost always a stock and cash deal reduces the supply of equity and is accretive to earnings—just not as much as pure cash deals.

These aren't radically new ideas. Anyone who took accounting or perhaps Economics 101 in college (meaning lots of folks) should know the difference between accretive and dilutive. What's more, you can easily monitor which firms are doing takeovers and which ones are dilutive or accretive. In our über-regulated business world, we get plenty of notice when a company launches a merger, acquisition, IPO, new stock issue, a global plot to steal oil—you name it. We know when the mergers are taking place, for how much, and in what form.

Merger manias financed by newly created shares increase the supply of equity and are bearish. Merger manias transacted for cash destroy stock supply; reduced supply means prices should rise, which means time periods following increased cash merger activity, other things being equal, should see perfectly fine stock returns. But few people see the difference.

Before tackling what you can know about the impact of cash mergers on the stock market, we must delve into what really drives stock prices. This combines Question One and Question Two. There are countless myths regarding what people think cause price movements you can debunk with Question One. But Question Two—what can you fathom about what causes stock prices to move that others cannot fathom—is easy. Way too easy for humans to want to fathom.

There are just two factors in this whole, wide, wonderful, and whacky world driving stock prices. Always and everywhere, stock prices are derived singularly by shifts in supply and demand. I've said so throughout the book, but sometimes the easiest concepts are the toughest for human minds to accept. Supply and demand are commonly known concepts, but few investors make the cognitive leap to securities pricing. Most folks who took college economics forgot about supply and demand as fast as possible after finishing finals, and never thought about securities prices in terms of supply and demand. Folks with PhDs in economics were trained but usually not in securities prices, and decades later don't think in terms of supply and demand for securities.

Myriad brokerage firm "research" reports tell you where they see the market going but almost never based on analysis of supply and demand shifts. Your news anchor, poli-tic, stockbroker, or tennis partner wants you to believe it's any number of economic or technical indicators, pop-culture concerns, political conspiracies, or self-fulfilling prophecies driving stock prices. Go to your favorite finance web site and you'll see:

You never hear a talking head say, "Supply of stocks remained stable today, but demand increased for reasons we can only guess about, causing stock prices to rise." It's boring. Supply and demand of stocks as a storyline doesn't sell advertising or influence you to a particular side in a political, social, or economic feud. There is no reason why media would be so understated. These two dueling pressures set prices of all we buy. Seeming pressures, such as increased regulation or an alien space invasion, are just more forces on supply and demand—an alien invasion likely decreases demand for equities and increased securities regulation likely decreases supply of equities.

Supply and demand shifts explain why people eagerly pay extraordinary amounts for an original Beatles vinyl, an original Le Corbusier chair, or for a limited edition Star Wars poster—if those things float your boat. However, no one pays up for plain old paper clips. First, there are billions of paper clips floating neglected in office desk trays everywhere. Second, if you run short and don't feel like a run to your local Office Depot, you can use a binder clip or even a rubber band in a pinch. That's called substitution. Things with easy substitutes never command premium pricing like those that can't be replaced. Third, paperclips are easy to make. Unless Andy Warhol bent a particular paperclip into a reasonable rendering of Marilyn Monroe, a paperclip won't fetch much of a premium.

In college economics, your professor should have told you supply and demand are both about eagerness. Eagerness is emotional. Demand describes how emotionally eager consumers are to buy something at varying prices. Typically, but not always, at higher prices, consumers want less of something than at lower prices. Makes sense! Alternately, supply is a concept depicting how eager suppliers are to generate output of some good or service at varying prices. Generally, but not always, suppliers want to produce more of something at higher prices than at lower prices. If the price is low enough, they won't want to produce at all.

It starts getting interesting when either producers or consumers become more eager to supply or consume at the same prices. If producers become more eager to supply—meaning supply increased—but consumers aren't any more eager to consume, the market floods with supply and prices drop. You say, "Why would suppliers ever do that?" Maybe new technology cuts their costs and prods their eagerness—sort of like Moore's Law pushed the semiconductor learning curve to lower prices for decades, making electronics firms ever more eager to make more at lower prices. On the flip side, if consumers become more eager—meaning demand rose—but producers don't step up supply to match increased demand, prices rise. Straight-forward.

Eagerness to buy or eagerness to supply can shift for psychological reasons deriving from any number of factors. After all, eagerness is an emotion and emotion is psychological. And markets are psychological. All I've said on this is pretty much a simplification and summary of what you would hear in any economics class—nothing remotely controversial.

But supply and demand are a little different when it comes to securities in several ways. Unless you did very unusual work in graduate school, you never saw any college study of supply and demand for equities. Demand for equities is about the eagerness to own or not own existing securities. Do we want to own GE stock more than we want to own a bond or an Andy Warhol Marilyn Monroe paperclip? Has that changed for some reason? How do we feel about owning GE stock versus Pfizer? The aggregate emotion of demand for equities can shift within the bandwidth of our human emotion very quickly and freely in just the same way tempers can flair or a movie can suddenly make you cry or laugh. Witness this by watching the volume of daily shares traded. In our super-connected world, people can become worked up and decide to buy or sell, and within moments complete a transaction. If their eagerness waxes or wanes, they can nearly instantaneously act in massive volume. They can completely reverse course hours, days, or months later if they are so inclined—emotionally.

Demand can shift fast, but only as far as people can become emotionally eager or un-eager. See it like this—you can only be as angry as you get or as happy as you get and you can quickly swing from one extreme to the other in the right circumstances, but at the extreme only as far as you go personally. Someone else might get a lot angrier than you do or a lot more giddy. Maybe you suffer depression. Some people do. Others don't—ever. Maybe you're manic depressive, heaven help you. Maybe you're very steady rolling—maybe too much so and your spouse complains about that. We vary a lot individually but overall as a group we're average. For people as a whole, total demand only shifts within the average bandwidth of our aggregate emotion, although it can do that quickly—nearly instantaneously. Think how much emotion shifted in the hours after 9/11. Hence, demand has a tremendously powerful effect on pricing in the short-term because it can shift so fast. It has less power in the long term because it can only shift within our emotional bandwidth and not further. It can only go so far.

Think of this differently. It's hard for you to keep your emotions at extreme levels for long. This is why most folks can't stay extremely angry or giddy very long. It's just like that super party when you were 23 on a warm summer night where you had a few drinks and the right friends and circumstances—it was just perfect—and you felt perfect. But the next day you felt tired. Things scar some of us sometimes and as individuals we never get over them. As we live life, those things have changed us. But newly changed—for good or bad—we only get so high or low. Altogether, when we get very angry or very ecstatic, we tend not to stay that way too long because there is too much energy exerted in staying away from our emotional norm. Shifts in demand tend to be forceful, fast, not too far, and then revert to the mean with time. This is part of why demand shifts impact short-term pricing so much more than long-term pricing.

Shifts in supply are different. In the short run, the actual supply of securities is almost completely fixed as it takes time and effort and a cooperative multiplicity of players to create new shares or destroy existing ones. Think about how long IPOs or mergers—or even just a debt offering—need to evolve, and the amount of advance notice the companies are required by law to give the public. An increase in supply technically means increased eagerness to supply equities. But initial eagerness is dampened early on because no one is actually sure if the deal can be pulled off. There is no assurance all the necessary pieces will come together for that offering—a process which will take many months if it happens at all. You can't be overly eager about something you know may not happen. Eagerness on a deal grows over the time period in which the deal is successfully pursued.

Take a new stock offering or IPO, which you already know means "initial public offering" or as I call it, "it's probably over-priced." Or a debt offering. When a company decides to issue stock or debt, they first must find an investment banker to manage the process. That alone takes time, particularly if they create a competition between several investment banking firms, which is common. At this point, the potential issuer doesn't know what the deal might look like, if they will go through with it, if they can go through with it, or even when it can happen should they be willing and able to do it. The investment banker will require freshly audited financials from a major auditing firm—typically one of the "Big Four"—also taking time. Then, in an equally uncertain process in a debt offering, the investment banker works with the issuer to secure an adequate rating from the three main rating agencies: Moody's, Standard & Poor's, and Fitch. Also in parallel, they start the filing process with regulators who must approve the offering—from the Securities and Exchange Commission (SEC) federally down to the state regulators in every state where the issue is to be sold (or appropriate regulator overseas such as the Financial Services Authority [FSA] in Britain). Then, they market the deal, which takes another few months. It's only toward the end of that process the issuer has any real sense of how eager they can be to offer the securities or not.

Maybe by the time all this is done, the market has faded. Maybe it's fading throughout the marketing process. Maybe a similar competitor got to market two months ahead of you, beating you to the punch and sapping demand in your category of offering. Plenty of deals get pulled at the last minute. Think how depressing that can be.

Under the best of circumstances, when the stars align, this is never a speedy, painless process, allowing you to assume supply is pretty well-fixed in the short-term. Conversely, no matter what anyone would have you believe, no one has any way to predict supply in the far distant future. This is among the reasons why long-term mechanical forecasting notions are usually way, way wide of the mark. No one knows what whacky things may happen to the creation or destruction of supply of equities 5 to 20 years from now. If you hear someone forecasting stocks to be a good or bad investment over the next i0 or 20 years, you're dealing with someone who is telling you more about what they don't know about how capital markets work than what they do know.

Stock prices 10 years out will be determined more by what happens to supply 7, 8, and 9 years from now than anything else. No one in 2007 has any capital markets technology or know-how allowing them to predict such a thing. In general, stocks are more positive than negative. Beyond that generality, no one should make a forecast for more than 12 to 24 months ahead. Said alternatively, shifts in demand are often more powerful in the short-term and shifts in supply are regularly more powerful in the long term. Sometimes you can see shifts in demand others don't see—justifying a 12 to 24 month forecast. But longer than that, you're just peering into fog. In the very long term, demand will bounce from very low to very high many times, but supply, subject to fundamental forces, can be almost infinitely bullish or bearish if the right conditions exist to increase new supply or destroy it.

Because supply of securities is relatively fixed over the short term, all you need do as an investor in most times is measure demand. Figure out the direction of demand and you've figured out how to make a short-term forecast. (Usually—sometimes you must account for supply—we get to that later.) That is something your fellow investors probably aren't seeing clearly, and something you can know they typically don't. And they won't just because I wrote this book. Set aside everything else—what you hear in the media, what you hear from friends, what so-called experts tell you about technical or fundamental investing—and focus on what impacts demand. For this, the Three Questions are handy. There are three broad forces at play impacting investor demand—economic, political, and sentiment.

SUPPLY AND DEMAND CURVES

What I'm going to show you now pretty much no one in the world has seen. It's a fun, activity-filled way you can demonstrate for yourself the power of supply and demand on security prices. The following figure on the left represents supply of equities and the figure on the right represents demand:

The supply curve is S-shaped, showing an increase in aggregate supply as prices increase. When prices are very low, supply tends to be low. And why not? This is like anything else. When prices (P) are low enough, firms won't want to issue new shares. If you were a CEO, you wouldn't be eager to issue new shares at four times earnings (an E/P of 25 percent) when you could always borrow money much cheaper than that. Conversely, above some break point, the higher the price, the more securities a firm would like to issue. Why? As the price rises, the cost of raising capital gets ever cheaper in direct proportion to the stock price increase. At a certain price level, suppliers would offer virtually infinite quantities of shares—as firms have an endless, infinite desire to issue more shares if their cost of capital is effectively zero. Think of a firm with a real P/E of 1,000 (an E/P of 1/1,000)—an annual cost after tax of 0.1 percent. At that cost of capital, why not issue infinite shares? You do so—buy a Treasury and make your earnings per share (EPS) increase almost infinitely. So, the supply curve flattens as it runs out to infinity along the quantity line (Q).

The demand curve is a backward-bending hyperbole. If you study economics, they never expose you to backward-bending demand curves until graduate school, if then. At one extreme, when the price of a stock is low enough, quantity demanded becomes 100 percent. Think of a corporation already in bankruptcy that you could buy for $20. I don't mean $20 per share—I mean the whole firm for $20. Since a corporation can't pass losses onto to its owners like a general partnership, you have nothing to lose by buying the whole outfit. Anyone in their right mind would buy the whole thing. You can control it if you want, ignore it if you want. If something good comes of it, you make the profit. If nothing good comes of it—no skin off your nose. How about at $25! You would buy that, too, just be out one more beer at the end of the transaction. As the price climbs, you would still take over the whole company, with slightly decreasing eagerness as the price rises. At a certain price, everything gets rational. The higher the price, the less you want, just like they taught you in college. When the price rises 20 percent, you still might like the company and be eager about it but not as eager as you were at the lower price.

Suddenly, above a certain price, weird things start happening. This is where a value company stops being thought of as a value company and starts being thought of as a growth company. Now the higher the price, the more prestige associated with owning the stock. The more the stock goes up, the more eagerness there is for it, and the quantity of stock demanded at any price rises. This is Microsoft throughout the 1990s; Yahoo! in 1999. This represents euphoric demand, something like what we might see at a bubble's peak. Instead of growth stocks, some call these "glamour" stocks—as prices rise, demand also rises because of the glamour. value investors view this as irrational. For example, from 1995 to 2000, prior to the tech bubble bursting, increasing demand occurred for tech stocks as prices rose. Qualcomm, Amazon, eBay, and all the rest—they were stocks investors felt they just had to own, and the higher the price, the more they felt it. The same is true of Google more recently. It's within this realm a bubble forms—higher prices actually lead to a higher quantity demanded.

Try this exercise. Copy each curve on a separate piece of near transparent paper, making them the same scale. Lay the demand curve over the supply curve, lining up each axis. The intersection of the curves represents current pricing, and you should get something like the figure below:

Remember when you were in college and they did those stick drawings of supply and demand? An increase meant the whole curve moved to the right, a decrease to the left. The shifting to the right—an increase in demand—meant that at every price people were eager for more. A decrease in demand meant a shift to the left where at every price people were less eager for the item. An increase in supply meant a shift to the right so that at any price suppliers wanted to supply more (maybe because of new technology or changes in laws). And a decrease in supply meant the whole curve shifted to the left, reflecting suppliers less eager at every price. So play with the curves you've drawn just like that and weird things pop out.

Slide the demand curve just a skosh to the right, representing an increase in aggregate demand in the short run. This leads very logically to higher prices. Move the curve back a bit to the left (decreasing demand) and prices fall. Now move your demand curve far enough to the right so the supply curve passes the inflection point on the demand curve and begins to run up the backward bend of the hyperbole. As this occurs, the supply and demand curves seemingly overlap for an extended series of prices, leading to nonlinear pricing. The price explodes upward. In this overlapping area, momentum investing quickly becomes glamorous ("glamour" stocks) and prices increase dramatically—just as many of those dot-com stocks did in 1999.

If you move the demand curve back, even just a bit to the left, reflecting a slight decrease in demand, or the supply curve to the right, demonstrating an increase in aggregate supply, you can see how quickly a glamour stock can fall out of favor, leading rapidly to lower prices. Just as fast as it went up. Recall again just how quickly the hot dot-com stock prices imploded in 2000. This is exactly what was happening. The increase in supply overtook demand in this same region causing the bubble to burst and then demand fell, driving tech through the floor.

Playing with the graphs in this way shows the naturally occurring decrease or increase in prices for stocks or categories of stocks as a result of shifts in supply and demand. Repeating this simple exercise whenever you see seemingly weird price action will help you understand it. In the short term, demand has the most influence on pricing, while over the long term, pricing is almost completely a function of supply. Play it and see.

When headlines are most dour and your friends and colleagues are bemoaning how terrible things are, you can be confident they will feel better later and sentiment will improve. Those who were most worried and sold their stocks low with hindsight bias gradually regain confidence and begin buying again. An initial reaction to higher prices is glee. You get pulled back to the middle of your emotional bandwidth by fear of heights. New higher prices scare people. Since they didn't expect stocks to rise as much as they did, they now fear they may fall. Since investors fear losses more than they enjoy prospects of gains, this creates rising anxiety. This is the proverbial "wall of worry" bull markets climb. The higher it goes, the more angst those who didn't predict it feel. Since they didn't see why it should go up, they can't see why it shouldn't go down. Since they hate losses much more than they like gains, the fear of downside dominates.

A good illustration of this is the first-year returns following a bear market. When people assume they face the most market risk, they miss out on a remarkably low-risk period. First-year returns following true bear markets are super above-average, as shown here:

The reason the bell curves I showed you in Chapter 4 worked for equities is they're a good measure of sentiment. The bell curves showed where sentiment was at a point in time, not where it was going. If you know and accept that, you can game the future direction. For example, in the late 1990s, the forecasting consensus wasn't bullish enough. Markets came in high because demand was too low and had to move higher. The bell curves were a good capital markets technology innovation for measuring investor sentiment.

Supply is like an unending accordion that can be expanded or contracted continuously. Other than what the market can bear, there is no limit to how many shares may be issued in IPOs or re-issues or how much debt can be raised if underlying economics justify it. Or how many shares can be bought back and destroyed through stock buy-backs or cash-based takeovers.

When there is sufficient incentive to flood the market with new supply, prices will eventually drop, overpowering any demand. This is how it works. Take a hot sector, like tech in the late-1990s. As prices appreciate rapidly, everyone wants in on the action. Suppose Firm A makes a novel product and has a total private market value of $1 billion. It floats a hot offering at a high price raising lots of money while giving up very little control of the company—they raise $250 million but only give up 20 percent of the company in newly created shares to do so. The prior existing 80 percent of the shares remain as previously held. Effectively that values Firm A before the money at $1 billion. With the money the deal is completed at $1.25 billion. The founders and other shareholders who initially had private stock of questionable liquidity now have a public security with a daily price making them multimillionaires. They're happy. The investment bankers are thrilled with their 7 percent of the $250 million—$17.5 million in fees!

Eager observers watch the postoffering price rise and hope the market can handle an offering from another similar outfit. So they find an entrepreneur and venture capital and create privately held Firm B, which is a Firm A look-alike. They get their investment banker to take Firm B public to get in on the cheap money. Maybe they have just a plan and no revenue, like many of the 1990s dot-coms. If B's offering goes well, someone else will attempt it with Firms C, D, E, and even F. This can go all the way to A-2, B-2, C-2, and on.

Firm A now realizes, as the high-quality, granddaddy of this product line, it can raise more capital with more newly created shares. It senses it can garner premium valuations over the group of inexperienced newbies and wannabe outfits. This time it raises another $350 million, but only gives up 17.5 percent of Firm A in newly created shares. Now Firm A is valued at $2 billion.

Now Company X, a mature, boring firm worth $100 billion, decides it can't take the risk of not being in on the hot new product category. They initiate a hostile takeover bid to acquire Company A for $3 billion, paid for with new Company X stock. Company A shares disappear and are replaced with new Company X shares worth $1 billion more than the $2 billion Company A previously had been selling for. Again, Company A shareholders get rewarded but, suddenly, there are a lot more newly created shares. Earnings are the same as before. This, like most stock mergers, was dilutive to earnings. It's the same amount of earnings but many more shares. All the IPOs and new issues start flooding the market with shares in the hot category. Eventually, supply drowns demand and prices roll over. If demand drops, prices implode.

Just as they did when the tech market crashed close on the heels of the tech-IPO craze in March, 2000.^[136] Demand fell all the way to the market's ultimate global double bottom in 2002 and 2003.^[137] The scapegoats were many for the tech bubble. People blamed tech companies for being overvalued. I'm not sure what that means—companies are worth what people pay for them at a point in time. If investors pay a high price for a dopey outfit with no discernable business strategy, that's the investor's fault, not the company's. Greedy CEOs got their share of blame, too. Corporate accounting rules were deemed too lax or not expansive enough.

The reality was the tech bubble burst because the market was inundated with supply and demand couldn't keep pace and then fell. That is the only explanation. Some would blame investment bankers, but that isn't fair or appropriate—no matter how you feel about them. Investment bankers simply respond to investor eagerness for more supply (demand). The real culprits (say it with me) were investors' overconfident brains, letting them run rampant and overallocate to a sector. Investors were too eager—demand was too high. Absent their demand, investment bankers and issuers can't flood the market with supply.

You should pretty much always be wary about excessive euphoria regarding IPOs in the latest "hot sector." Every time we see a hot sector—throughout the entire history of investing—investors claim, "It's different this time." It's never really different this time—just the niggly details. There is never anything different about an inundation of supply surpassing demand and causing prices to drop. (For more evidence on how it's never different this time, see the following reprint of my March 6, 2000, Forbes column "1980 Revisited," calling the top of the tech bubble due to parallels to the 1980 energy bubble.)

Forbes, March 6, 2000. Reprinted by permission of Forbes magazine. © Forbes, 2006.

Supply of stock can increase infinitely (which wouldn't be so good for stock prices in the long term) but may also be reduced when a company, thinking its stock is too cheap, uses cash to repurchase its own shares. Through stock buy-backs, as discussed in Chapter 6, and cash-based takeovers as discussed earlier, supply can be destroyed nearly infinitely. Using Question Two, we know cash-based merger manias should be followed by good stock market returns. If demand remains the same (or even greater) but supply is reduced, prices must rise. What does this mean for you right now in 2007? Because stock destruction has been occurring on a large and sustained scale, this should be bullish as you position for 2007 and possibly 2008 if supply doesn't start growing again. Whereas cash takeovers were less than a $1 billion a year in America in 2002, by 2006 they were running at more than a $50 billion a year. Outside America it was bigger still. All else being equal, massive reduction in supply should help drive demand and stock prices up. Naturally, it won't be your only bullish factor—but it might be a major counter to any bearish concerns.

Suppose you didn't buy this book in its first printing—how does knowing this Question Two truth help you? Simply keep in mind the difference between equity-based (dilutive) and cash (accretive) mergers. Are there a lot of IPOs hitting the market, and on average more equity-based mergers taking place? That's a potentially bearish concern. Conversely, lots of cash mergers probably present a little-noticed bullish surprise—news most investors don't process correctly because they don't know how.

Knowing increased cash-takeover activity leads to better stock markets helps you forecast the broad market's direction. But does that provide additional insight into which sectors you should overweight, and which individual stocks you may want to buy? Abso-positive-alutely! Look at the sectors where the mergers are occurring and work your way, top-down, to a good buy-out target. If you're right on a few of your buy-out targets, you get a nice price bump if (and when) the merger is announced. It's easy, free money. (If you're not sure how to do that, the following gives you ways to identify buy-out targets and a few examples.)

Categorically, you know the bulk of cash-based deals will occur with stocks that are cheap in terms of having a high earnings yield compared to the acquirer's pretax cost of long-term borrowing. Suppose the average company borrowing rate (the BBB 10-year bond rate) is 6 percent and the average corporate tax rate is 33 percent. The after-tax average cost of borrowing is therefore 4 percent. Takeover targets will tend to have earnings yields greater than 4 percent after they've been marked up with a maybe 25 percent pricing premium. Hence, most takeover targets will have an earnings yield above 5 percent before the deal is announced, translating to a P/E below 20. To get the acquirer's earnings per share to rise the most from the deal, the higher the earnings yield the better. Most cash-based takeovers will tend to be value stocks with low P/Es (high earnings yields). Seek those kinds of stocks to capitalize on cash-merger mania.

Supply and demand being the only determinants of stock pricing—and the potential to create or destroy new shares being nearly infinite—is why no correctly calculated index, size, style, country, or category is better for all time. (Remember our graphs in Chapter 4?) While collectors of a particular category type (small-cap value, large-cap growth, Japan, bio-tech) believe the category they like is permanently better, it isn't and can't be.

But when an equity category collector tells you his or her category is permanently better—and they do all the time—you're being told what the teller doesn't understand about markets. Supply creation is infinitely elastic if given enough time in the right circumstances. And demand bounces constantly in the short to intermediate term. There is no evidence supply of any equity category is capped, can't be bought back and destroyed, or is in anyway predictable in the long term. Consider this—if there is a demand for a category, the investment bankers will meet it—they don't care about investor perception about a particular category needing to be superior over time.

Since 2000, small-cap value has been hot. I'll give you a simple tip. Whenever big-cap growth does lousy, small-cap value does well—they are polar style opposites. Saying one does well is the same as saying the other does badly. Nowadays, there are many investors saying small-cap value is permanently better. I started doing small-cap value stocks three decades ago, long before the word small-cap value existed. My first book Super Stocks (published in 1984) was about PSRs—but specifically how to use PSRs to find small-cap value stocks others couldn't find. Even then the term small-cap value didn't exist. The term evolved in the mid-1980s off the heels of that earlier period as small-cap value stocks did well. A period much like the past six years.

In 1989, when Callan Associates, a major consulting firm to institutions (primarily defined benefit pension plans), introduced the very first small-cap value peer group for institutional investors to use in calibrating how well or badly a given manager did, there were only 12 of us included in that initial group. They couldn't find any other pure-play small-cap value managers. That was how primitive this category was not quite 20 years ago.

Today my firm still manages well over a billion dollars in the category for large defined benefit pension plans, endowments, and foundations. It's a perfectly valid part of the market to include in a much broader portfolio (which all these institutional investors have). But the category has times when it shines, and times it's a real dog. Folks forget that—many who should know better.

One of America's top scholarly minds, a novo-unabashed small-cap value fan, penned an opinion article for the editorial page of the Wall Street Journal published June 14, 2006. He stated emphatically small-cap value is better for all time based on long-term history. Wrong! Small value's supposed long-term superiority is somewhat of a data mine. It's in the data, but isn't harvestable in a real sense, as I showed you in Chapter 4. You can go through periods long enough to lose your mind where small-cap value is the worst performing part of the market—decades. If you must wait two decades for superiority, there isn't really superiority.

Despite the period from 1928 (which is as far back as small-cap value has been measured) demonstrating small-cap value stocks doing better than large stocks or the whole market,^[144] most of that small-cap return came from terribly tiny stocks—ones too small to own without having a very illiquid and risky portfolio. No one ever mentions that. Also, these companies had much higher bid-ask spreads in early history. Back in the 1930s and 1940s, the bid-ask spreads of these tiny stocks were often 20 percent to 30 percent of the purchase price and those spreads aren't adjusted for in the calculation. Doing an in-and-out ate up most of the return just in the give-up between the bid and ask—all unaccounted for transaction costs.

I'm not arguing against owning small-cap value, or for owning big-cap, or the market as a whole. I'm saying there are painfully long stretches when things seeming to work in the very long-term don't actually work. And these times are too long to not drive everyone, including you, nuts. For periods of 5, 10, or 20 years, it will be shifts in supply determining most of the return of the market and of the subsets of the market. In the very long term, and lots of subsets thereof, all major categories, correctly calculated will have very similar returns. Falling in perpetual perma-love with some category won't get you superior perma-future return.

Different currencies are simply flavors of money identified by their issuers (central banks), and their banking systems. Because they're commodities traded on free and open markets, they derive their relative value in the same way as other assets, by supply and demand.

An exchange rate reflects the value of one currency quoted in another currency's terms. It's entirely relative and has no absolute meaning otherwise. Each particular exchange rate is driven by a complex combination of the supply and demand characteristics of each of the two currencies. Relative increases in demand or decreases in supply will drive one currency's exchange rate up versus another, and vice versa.

Time for another Question Two: What can you see driving currencies and demand for them others can't? There are a few obvious factors contributing to short-term shifts in supply and demand for currencies. First, non-discretionary central bank operations. When a country pegs its currency to another currency (the Chinese yuan to the U.S. dollar, for example), the pegging central bank must either buy or sell the other currency to maintain the relationship. Second, when one country's economy grows faster than another, the demand for its currency increases because more transactions take place in that currency. Both of these are easy to fathom—you don't need Question Two for them. But what else could drive currencies? What can you fathom?

Each and every day, speculators make bets on exchange rates through what is called a carry trade. A carry trade works thusly: You borrow short-term money in one currency, convert it to another currency, and buy a short-term bond (though you might choose to make a longer-term bet with a longer-term bond) in the new currency. The idea is to borrow at a lower interest rate and buy a bond yielding a higher rate on the presumption the higher yielding rate won't fall enough to reverse the interest rate spread during the period you hold the bond. The difference between the two rates is free money, and everyone likes free money.

The key is to borrow in a currency you think won't appreciate markedly against the higher interest rate currency where you will park the money—a great Question Two. Since you are selling the borrowed currency and buying the currency you lend into, if many people do this all at once, it tends to make the acquired currency appreciate. Then, you get not only the interest rate spread but also the appreciation on the currency. Icing on the cake. Very attractive.

It would be completely irrational to borrow at a higher interest rate and buy a bond with a lower interest rate. That is the reverse of free money. That's un-free money. So, if Country A's short-term rate is lower than Country B's, investors are more likely to borrow at Country A's lower rate and invest at Country B's higher rate, putting downward-selling pressure on A's currency and upward-buying pressure on B's currency. Currency prices then become a bit of a self-fulfilling prophesy, as carry trades take place in huge volumes daily.

In theory, it makes sense, but let's scope some actual scenarios to see if this is correct. Figure 7.3 shows the yield curves for the U.S., the U.K., Euro, and Japan at the beginning of 2004. At the short end of the curve, the U.S. curve is well below the U.K. and Euro, yet still above Japan. It so happens the dollar was weak that entire year. Investors were borrowing in America and investing in short-term instruments abroad, contributing further to a weak relative dollar. If you borrowed in America at a 1 percent six-month rate and lent into Euroland at above a 2 percent rate, you picked up the 1 percent spread as free and easy money as long as the Euro didn't fall in value. Since lots of people did it all at once, they sold dollars and bought Euros, pushing the dollar down and Euro up. The opportunity was even more extreme if you lent in Britain, which is the reason pound sterling was so strong.

Figure 7.3. Global Yield Curves January 1, 2004. Source: Bloomberg.

In 2005, after multiple Fed fund rate raises, the short end of the U.S. yield curve had risen above Germany and Japan, and was closing a lot of the gap with the United Kingdom. The dollar strengthened considerably during 2005 against pretty much every major world currency, as the carry trades started going in the other direction. Effectively, as the Fed raised short rates, it choked off the carry trades that had been holding the dollar down (see Figure 7.4).

The evidence supports this theory, but examine it further. Figure 7.5 shows the spread between U.S. and Euroland short-term rates over the past 20 years, as well as the dollar's relative strength (we substitute a GDP-weighted basket of European currencies prior to the euro's introduction in 1999). When the interest rate spread is increasing (meaning our short-term rate is getting higher than theirs), the dollar is generally strengthening against the euro, and when our short-term rate moves lower, the dollar is generally weakening. Not each and every year, as there are other supply pressures at work here as well, but enough to make this a somewhat reliable indicator.

It typically doesn't work when the market can somehow anticipate in advance the lower rate country will raise rates and hence choke off the currency carry trades. Then the currencies move in advance of the central banks, but normally, currency movements are overwhelmed by either interest rate spread differentials or speculation based on future interest spread differentials.

Figure 7.4. Global Yield Curves, January 1, 2005. Source: Bloomberg.

Figure 7.5. Interest Rates and Dollar Strength: Eurozone. Source: Bloomberg.

With some exceptions within developed Western nations, countries with higher short-term interest rates that keep moving higher tend to have the stronger currencies. Countries with low short-term interest rates that remain unexpectedly low tend to have weaker currencies. This pattern is compelling, and makes sound economic sense due to carry trade activity. Another way to say that is: Demand for a currency increases and the price with it when appropriately moving yield curve differentials between countries pay people to be more eager to own a given currency. This is why British pound sterling has been so strong, so long—they've kept their interest rates higher than everyone else's. Pretty simple! As the Fed paid up in 2005, people stopped borrowing in U.S. dollars, selling, and investing overseas, and instead started doing the reverse—borrowing overseas and buying dollars—then the dollar strengthened. Demand for currency, more than not, increases when central banks pay people to demand more of their currency—which relates to them adjusting their supply. What I'm telling you isn't unknown, but few notice it, and fewer still believe it, which is why it will have legs for some years. You can use this information to discount strong currency sentiment based on myths we debunked earlier in this chapter. And, you can use it for a rational basis for a market bet.

What if you can see the dollar's direction over the next year or so? First, you could trade the currency directly, like any other commodity. If you know what others don't, you have the basis for a bet. Second, what can you fathom clearly about the stock market if you can understand the dollar's direction? That would be a great Question Two. You now know the dollar's relative strength isn't predictive of stock prices. But the dollar's strength does matter when professionals base their forecasts on the dollar's direction as they did in 2005. When forecasters predict stock market doom and gloom tied to a dollar implosion, you've got something you can bet against. You have an advantage because fear of a false factor is bullish. In fact, if most folks fear a weak dollar will cause weak stock prices, but you can fathom the dollar won't weaken much, that is a bullish surprise helping sentiment and hence demand for stocks—despite no fundamental mechanistic connection—just like in 2005.

Investors talk about supply and demand, and know intuitively supply and demand drive prices, but just aren't applying these concepts to the securities, bonds, and commodities they buy. And if they do, they typically aren't thinking about supply or demand correctly. Now that you know securities pricing is always and everywhere a result of supply and demand, you can focus your energy on what counts and start to make more reliable 12-month forecasts. And that is something you can know that others don't. But how can you make a forecast? And how can you know what the market is more likely to do? For that, we move to Chapter 8.