Imagine you believe the market is due for a correction and thus you implement short positions. Specifically, you short individual companies in a few sectors — a tech or agriculture name for example. The very next day you find out that these names, Potash and 3Par for example, are now buyout targets by cash heavy corporations. (both of the aforementioned firms are currently in the midst of bidding wars) These two stocks explode upward in price, at the same time lifting similar companies in the industry. Those shorts would be very costly to unwind and certainly give you pause the next time you want to short individual names, right?
One interesting element of increased M&A activity in the market is the risk that almost any firm could be aggressively taken out by a variety of companies. This is due to the near record amount of cash on corporate balance sheets today. ($2 trillion plus) In my view, this interesting possibility is not lifting the market, but instead seems to be deploying a type of a safety net around valuations. The corporate world has body checked investors twice in the last two weeks sending a message that it will step in to make a strategic acquisition, especially if the valuation makes sense. (although as evidenced by the 3Par bidding war between HP and Dell, valuation could ramp quickly in a competitive situation) This possibility is curbing the appetite and decreasing the reward to short individual stocks unhedged. It should be a boon to geared inverse ETFs, which offer a more diversified way to be short, especially in lieu of shouldering company specific M&A risk.
I would expect ETF providers like ProShares and Direxion to see increased activity in their geared inverse equity offerings. This activity will likely come primarily from institutions and hedge funds, the sophisticated money. This is because, in a less than surprising twist, many retail investment firms won’t allow clients to purchase these ETFs — despite being a more prudent investment option for investors than shorting individual names. Go figure.