The increasing disconnect between U.S. stock prices and economic reality may seem surprising or even surreal to many investors. Not only did the recent "market crash" last for only a month, stock prices continue to rise even for companies that reported year-over-year declines, so long as they beat whatever the analyst community on Wall Street was predicting.
More than halfway through 2020, not only is the stock market thriving, we are also seeing a change in fortunes for special purpose acquisition companies, also known as SPACs or blank-check companies, which are highly speculative in nature as their success depends entirely on making (and managing) a favorable acquisition. According to Goldman Sachs (GS, Financial), a total of 50 SPAC offerings were completed in the seven months through July, which marks a 145% increase from the same period of 2019.
In addition to successful SPAC deals, there are also an increasing number of fledgling SPACs that have yet to find a deal for their investors. Activist investor Bill Ackman (Trades, Portfolio)'s $4 billion initial public offering of Pershing Square Tontine Holdings Ltd. (PSTH.U, Financial), the largest SPAC IPO to date, falls into this category.
Investors are typically wary of buying stocks when they trade at high valuations or when the companies behind them have no income (as is the case with SPACs). However, while times of economic crisis are typically great chances to pick up bargains, the window of opportunity this time was miniscule compared to historical market crashes, as illustrated in the S&P 500 charts below (broken up to more clearly show the paths of earlier economic cycles).
A brief intro to SPACs
For those who are not familiar with how SPACs work, things typically go like this: the founders of the group raise funds on the open market to bankroll an as-yet-unspecified acquisition. The founders typically (but not always) have a history of negotiating successful acquisitions. If enough investors sign on for the deal, the SPAC goes public in an IPO that is typically priced at around $10 per unit. Each unit normally consists of one stock plus one warrant that is exercisable at $11.50. The SPAC puts the money in a trust account and lets it accumulate interest until the founders manage to secure an acquisition deal.
Next, the founders present the idea to their shareholders, who can then vote whether they want to approve the deal or redeem their stock to get their $10 per unit back, plus any interest accumulated. If enough shareholders vote for the deal, then the acquisition goes through and the SPAC becomes a normal publicly traded company under the acquisition's name. If it fails, then all of the shareholders get their money back.
The SPAC bubble
For investors, SPACs have evolved to become virtually risk-free investments, at least in their initial stages. They provide free optionality on whether or not to buy into a newly public stock at a low price on some date in the future.
It may at first seem like more SPAC deals being completed is a good sign for the economy. After all, more companies going public means more money flowing through capital markets, resulting in positive news headlines. However, many economists are referring to the increase in SPAC deals in 2020 as a "SPAC bubble," and for good reason.
Basically, we have a combination of a weak economy and more SPACs being formed to look for deals. In other words, there is too much capital chasing too few opportunities. Not completing a deal in and of itself is not harmful to SPAC investors, but this situation of scarcity also increases the pressure on founders to get a deal done at any cost, even if it means buying a small tech startup that has no products on the market yet.
For example, following Nikola's (NKLA, Financial) successful entry into public markets via SPAC, at least three aspiring automakers have announced similar deals: Fisker, Lordstown Motors and Canoo. Some of these companies have yet to produce a vehicle for sale. Despite having no products as of yet, Canoo is being valued at $2.4 billion according to the SPAC deal and has approximately $600 million to invest in the production and launch of vehicles.
Why are Canoo and an increasing number of other companies choosing to skip the IPO route and go with SPACs instead, you might ask? The simple answer is that it is much less risky for the company, as it is signing a deal with one entity and can be sure of getting a fixed amount of money. With an IPO, the deal is announced before negotiating its size or price, and things could take a sharp turn for the worse if public enthusiasm is not high enough.
The thing to pay attention to here is the "public enthusiasm" part. Investor positivity toward new offerings can not only be unpredictable, it can also wane or die off during a stock market downturn or recession. Electric vehicle companies like Nikola and Canoo have no need to worry about a lukewarm reception during normal market conditions, so their choice to go with SPACs indicates they expect a high risk of the stock market taking a plunge in the near future. If a market downturn were to occur after the deal was sealed, the SPAC would still be on the hook for the same amount of money.
In summary, for investors, SPACs provide a source of low-risk optionality. For startups, they provide a source of funding that is far more certain than an IPO during market bubble conditions. This means that an increase in SPAC deals is a sign of a market bubble, which is certainly a red flag.
Other signs of market troubles
In addition to being a potent indicator of overvaluation in the stock market, the increase in SPACs is also a reflection of two other indicators of decreased income in a market – attempts to acquire new sources of income and high debt.
For every SPAC founder looking to acquire a company in an industry that they have in-depth knowledge in, there is bound to be at least one looking in industries they know next to nothing about. When the top brass of a company knows little to nothing about how to run it, we basically have "diworseification" without the benefit of existing revenue streams to fall back on. Diworseification is when a company makes an acquisition outside of its circle of competence, resulting in it losing money in its attempt to diversify. However, when business is bad in many existing companies, it becomes increasingly tempting to acquire new sources of income, even if it means paying top dollar.
Another problem that SPACs face is that the founders stand to lose millions or even billions of dollars if they fail to secure a deal, furhter incentivizing them to make a buy at any price. This becomes even more dangerous in the present case of an increasing number of SPACs to compete for opportunities. When combined with the fact that shareholders have the option to pull out of the deal, leaving the SPAC with less funding to complete the promised acquisition, there is more of a chance that the new public company will start off in debt.
Conclusion
In many ways, the 2020 SPAC market bubble is sending up red flags indicating the presence of an overall stock market bubble. Companies are afraid of an economic downturn ruining their chances should they go the IPO route, there is an increasing number of business owners looking for additional sources of income and debt is seen as the easy way out if it is needed to make an acquisition.
While the SPAC bubble can be a sweet deal for investors, providing low risk and high upside potential, these fledgling companies could be hit hard by the economic downturn that they seem to be expecting. Investors should pay attention to the red flags just as much if not more than the decreasing probability of betting on the right SPAC in this situation.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.
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