Companies ready to put cash to work

Supply and demand for shares have been an interesting dynamic in the equity market this year, driving strong returns and increasing valuations. Institutional and retail investors have allocated to stocks in record numbers in recent months as equity returns remain strong and fixed income lags. A wave of IPO activity threatens to shift that balance, but this has been more than offset by a resurgence of corporate buybacks of equity shares.

The next driver of equity share demand is likely to come from merger and acquisition (M&A) activity. Corporate leaders had a “deer in the headlights” reaction to the pandemic last year, choosing to retain capital and engaging in little acquisition and buyback activity. As the environment has improved, corporate cash balances have elevated. Companies now hold over 6.3% of assets in cash—two-thirds higher than the long-term average of 3.8%—and earning virtually no return. Already, we have seen a wave of acquisition announcements, setting the stage for record completions in coming quarters.

Substantial M&A activity is often seen in the later stages of a market run, making equities very difficult to short and contributing to outsized returns in certain stock sectors. At the extreme, however, it could indicate that companies are struggling to drive organic growth and are willing to take increased risks to drive profits. If that proves to be the case, it would signal that the market rally has become extended.