When a large part of one's business is subject to the varying fortunes of sports franchises, as is the case with Madison Square Garden (MSG), spinning off that part of the business makes perfect sense. If nothing else, it makes long-term planning for the remainder of the business a lot easier. That, however, is one specific set of circumstances and doesn't help to explain the volume of such deals and proposals that we have seen this year. There is another possible explanation, which sends a significant warning signal for the rest of this year and into 2015.
There have certainly been a lot of spinoff deals so far in 2014, including very high profile ones. ebay (EBAY) decided to spin off PayPal, Blackstone (BX) separated its investment advisory division from the rest of the firm, and Hewlett-Packard announced a separation between divisions. One research firm estimated that by the end of 2014, there would have been 62 such deals completed in the U.S. To put that number in context, it represents an increase of more than 67% over last year's total, and it is the highest number since 2000.
That last fact should give investors pause. Take a look at this chart from Spinoffresearch.com, showing the number of completed spinoff deals in each year since 1985.
What stands out most is that big spike in 1999 and 2000. Investors who were in the market at that time remember what followed. The so-called "tech wreck" of 2000 to 2002 saw the Nasdaq Composite lose 78% of its value, falling from a peak of 5,046.86 on March 11, 2000 to bottom at 1,114.11 on Oct. 9, 2002.
What sets this crisis apart from others is that it was almost entirely about valuation; it was a proper "bubble." The tragic events of Sept. 11, 2001 added to the problem for stocks, but the collapse started simply because valuations had gone out of hand. Many fear that the same is happening, despite the continued slow recovery of the U.S. and global economies.
Is there any reason that a spike in the number of spinoff deals could be a sign of an overvalued market? Simple logic would indicate that there is. Until the last couple of years, the mergers and acquisitions (M&A) departments of banks had handled mostly traditional growth-oriented mergers and buyouts. Special circumstances that had contributed to this phenomenon include the tax policy that resulted in the inversion craze earlier this year. Nevertheless, companies buy other companies for one simple reason: they think the targets are undervalued.
When companies chose to effectively shrink instead of grow, could it be they see themselves and others as overvalued? When the best way to increase shareholder value is to break up a company, the company must think of itself as overvalued. I doubt any CEO or board member would say that out loud, and I doubt they even think that consciously.
The market is not necessarily in a bubble, but the last period of extreme stock market overvaluation coincided with a spike in spin off deals. The market has returned to those levels. A correlation such as this strikes me as more of a reason to worry about stock market valuations than Ebola or ISIS. While I am still bullish on the economy, this gives me cause for concern about valuations. If nothing else, I will be keeping a close eye on the current trend over the next few months, and maybe you should too.