After a tumultuous 2020, the first few weeks of 2021 were eventful to say the least. From the rocky start of a new U.S. presidency to the troubled rollout of COVID-19 vaccines, January brought plenty of news with global implications.
Similar concerns have been raised about the growing popularity of special purpose acquisition companies (SPACs). Last year, SPAC initial public offerings (IPOs) raised a record $76 billion, a nearly six-fold increase from 2019, according to our colleagues in the Goldman Sachs Investment Strategy Group (ISG).
What are the implications of the proliferation of SPACs? In this edition of our monthly Market Commentary, we explore that question from the point of view of investors seeking to build wealth over time.
Let’s start by taking a brief look at what drove the GameStop mania. The stock’s eye-popping rally appeared to be driven by individual traders, who used online platforms to promote their positive views of the stock and generate interest from others. Their trading activity was facilitated by easy-to-use trading platforms. Meanwhile, institutional investors were betting that the stock would fall. And so came the short squeeze: Individuals bought the stock in increasing numbers, pushing the price higher in the early days of January. Then investors who were short the stock also had to buy shares in order to close out their short positions and limit their risk.
Ignore the Noise and Focus on Long-Term Investing
It’s easy to see how the hype surrounding certain investments might draw in some investors. But, as always, we recommend that clients focus on investing for the long-term, which means steering clear of frequent and highly speculative trading.
Research has shown a correlation between frequent trading among individual investors and inferior returns. One study found that buy-and-hold investors, after trading costs, outperformed high-turnover investors by about seven percentage points a year. Other research has shown that most individual investors suffer substantial losses on their options investments, owing largely to poor timing.
It’s also worth noting that retail investors tend to be drawn to certain types of stocks, namely those that get lots of media attention, experience wild price swings and/or have low share prices and high valuations, according to a recent study by Empirical Research Partners. The study also found that over the long term, the stocks favored by “retail investors” — individuals who buy and sell stocks on their own — delivered “no alpha,” in other words, they didn’t outperform the broader market.
The Rise of SPACs
Another area of the market that has gotten less media attention, but also suggests some excesses is the proliferation of SPACs. SPACs are not a new phenomenon, but they’ve become more prevalent over the past year because of market volatility, tied in part to the pandemic.
What’s a SPAC? It’s a company that’s usually created or sponsored by a team of institutional investors for the sole purpose of acquiring an existing private company, rather than operating as a stand-alone business. A SPAC raises money through an initial public offering (IPO) to make an unspecified acquisition.
At the time of their IPOs, SPACs have no stated acquisition targets, which is why they’re often called “blank check” companies. The money a SPAC raises through its IPO is held in an interest-bearing account(s) until an acquisition is made. Otherwise, it’s returned to investors.
SPAC IPOs not only raised a record amount of money last year, but, as of January 2021, had grown to represent a whopping 80% of the total IPO market, according to ISG. By contrast, SPACs as a share of total IPOs was less than 30% in 2019 and 53% in 2020.
During the pandemic, some private companies have opted to go public by merging with SPACs, rather than doing a traditional IPO during a time of heightened market volatility. Investors, meanwhile, increasingly see SPACs as a cash substitute with the potential for big gains associated with the acquisition of an early-stage private company, very often one in a fast-growing sector like Technology.
But it’s important to keep in mind that SPAC investors can, and have, suffered large losses. In fact, six months after the completion of a merger agreement, the median SPAC underperformed the broader U.S. equities market by a whopping 27% (with a range of outcomes from -77% to +109%) during the 13-month period ending in January 2021, according to ISG.
Pockets of Excessive Speculation, Not a Bubble
Although we’ve seen some evidence of excessive speculation in some parts of the equities market we don’t believe such risks are symptomatic of a bubble.
U.S. equities have actually seen outflows for six consecutive years, in contrast to the massive inflows preceding the technology bubble of 2020, according to ISG. And while equity valuations are high on an absolute basis relative to history, they’re supported by low interest rates and largely positive corporate earnings growth.
According to ISG, S&P 500 stocks with excessive valuations — which it defines as those with earnings yields lower than that of the U.S. 10-year Treasury bond — account for only about 7% of market capitalization today versus some 80% at the peak of the dot-com bubble.
The Road to Recovery
Despite near-term headwinds, we expect the U.S. equities market to be buoyed this year by an improving economy and strong corporate earnings growth. After finishing 2020 with a return in the high teens, the market, as measured by the S&P 500 index, suffered a modest decline in January.
According to its 2021 Outlook, ISG expects the U.S. economy to grow by 5.4% this year, a forecast that assumes widespread vaccinations bring the pandemic under control by the latter half of the year.
According to ISG, the downside risks to its growth forecast include potential future adverse pandemic-related developments, such as a slower-than-anticipated vaccine rollout, the continued spread of virus variants and lower-than-anticipated vaccine efficacy. However, there is also a significant upside risk to ISG’s forecast in the form of a possible new large fiscal stimulus package in the U.S. In January, President Biden unveiled a $1.9 trillion coronavirus relief plan, which ISG did not factor into its original growth forecast for 2021. Although Biden’s plan faces hurdles in Congress, we’re likely to see some amount of additional fiscal stimulus in the near term.
Against an anticipated favorable economic backdrop, ISG’s base case for S&P 500 company earnings growth in 2021 is slightly more than 25% per share, according to its 2021 Outlook.
To be sure, this new year has already given us plenty to think about. But you don’t need to go it alone. If you have any questions about how recent developments might impact the markets, the economy or your portfolio, don’t hesitate to reach out to your financial advisor. That’s what they’re there for.
Invest well and stay healthy,
Kara Murphy, CFA
Chief Investment Officer
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S&P 500 Index: A broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. It is a capitalization-weighted, unmanaged index that is calculated on a total return basis with dividends reinvested. The S&P 500 represents about 75% of the NYSE market capitalization.
Russell 2000 Index: This index measures the performance of approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks; the index serves as a benchmark for small-cap U.S. stocks.
MSCI Europe, Australasia, and Far East (EAFE) Index: This index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.
MSCI Emerging Markets Index: This index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of June 2009, the MSCI Emerging Markets Index consisted of the following 22 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
Bloomberg Barclays U.S. Aggregate Bond Index: This is a market capitalization weighted bond index of investment-grade, USD-denominated fixed-income securities.
U.S. High Yield Corporate: The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
U.S. Investment Grade Corporate: The Bloomberg Barclays U.S. Corporate Bond Index measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers.
Bloomberg Barclays Municipal Bond Index: The Bloomberg Barclays U.S. Municipal Index covers the USD-denominated, long-term, tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.
S&P 500 GICS Sectors Level-1: In 1999, MSCI and S&P Global developed the Global Industry Classification Standard (GICS) to offer an efficient investment tool to capture the breadth, depth, and evolution of industry sectors. GICS is a four-tiered, hierarchical industry classification system. It consists of 11 sectors, 24 industry groups, 68 industries, and 157 sub-industries. Companies are classified quantitatively and qualitatively. Each company is assigned a single GICS classification at the sub-industry level according to its principal business activity. MSCI and S&P Global use revenues as a key factor in determining a firm’s principal business activity. Earnings and market perception, however, are also recognized as important and relevant information for classification purposes and are considered during the annual review process.
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