Will Reverse Mergers Jump on
Improving Sentiment Bandwagon?

European Central BankOver the past two months, a combination of supportive policy actions and stronger economic data releases drove up market sentiment and buying in stocks.

While stocks in Europe are stalling, it’s a different story here, as the key stock indices recorded the strongest January gains in years driven by bullish market sentiment.

While there are concerns of another recession surfacing in Europe, we are seeing a concerted global effort by the world’s central bankers to avoid slowing. The Fed is maintaining low interest rates and suggests no increase until at least late 2014. The European Central Bank left its key rates unchanged and is providing adequate liquidity to the banking system. In Asia, the central banks of Indonesia, the Philippines, and Thailand have lowered rates; whereas India and China have started reducing reserve requirements. There are signs of improved liquidity situation in the markets, which has also fuelled interest towards the equity markets; thereby driving up the market sentiment.

The eurozone’s worsening sovereign debt problem remains the primary concern for the equity investors that could impact market sentiment. The sharply rising debt burden of the developed economies is likely to force them to implement more restraint, which will likely impact the economic growth of these nations and also global growth during 2012.

But, while the overall market sentiment is bullish, the market sentiment towards reverse mergers remains bearish.

The month-on-month performance of the Bloomberg Chinese Reverse Mergers Index (CHINARTO Index), which is a market capitalization weighted index that tracks China-based companies that trade on U.S. exchanges following reverse mergers, suggests some relief and probably a positive recovery. The index grew by 15.5% during the month of January. This is also the best monthly performance for the index since June 2009. Volume has been on a consistent decline since April 2011. In terms of valuations, CHINARTO is trading at a price-to-earnings (P/E) ratio of 4.58x and a price-to-book (P/B) ratio of 0.51x compared to S&P’s P/E of 13.98x and P/B of 2.2x, so there is value, but the risk is high.

Reverse-merger stocks have been the underdogs since last year, witnessing a consistent decline in prices and yet there seem to be no signs of reversal in market sentiment.

Despite last month’s performance of the CHINARTO Index, it is hard to say whether the current valuations are cheap enough to go long in reverse-merger stocks or the sector will still be driven by the prevailing negative psychology towards the sector.

One interesting thing to note from the historical chart for the index is that it has tested and rebounded from the support level. This might be an indication that the index has bottomed out and may be moving towards a possible rebound driven by more positive market sentiment.

Investing in reverse mergers, especially Chinese assets, can be difficult. There is a certain amount of trust that investors must have in order to put their money into these reverse-merger stocks. Strong financial performance, sound business models, and visibility in earnings are the likely companies in the space at which an investor should aim. Still there are companies that have the potential to multiply the amount invested in them; but, for this to happen, the overall market sentiment towards this class must improve.

Apple Inc. (NASDAQ/AAPL) just surpassed Exxon Mobil to become the biggest company in the world based on market capitalization. In my view, Apple is a great “widow” stock, as I discussed in Tech Stock Wars: I Would Buy an iPad Over a PlayBook.