The stock market has been posting solid gains of late, with the S&P 500 rising +4.4% in March and up +6.2% for the first quarter. Massive liquidity measures – courtesy of the Federal Reserve and federal government stimulus – are supporting higher prices, as are rising expectations for strong earnings and GDP growth in 2021.1 My outlook remains largely positive for the year.
At the same time, I have been noticing a trend of investors moving too far out onto the risk curve, and I am starting to see signs of froth in certain areas of the market. Investors are reaching into unproven asset classes like SPACs and cryptocurrencies for extra returns, while paying sometimes exorbitant premiums for future cash flows. There appears to be a sense that money can be made anywhere and easily in this market, which gives me some pause.
At Zacks Investment Management, our best defense against overt risk-taking in ‘haywire’ asset classes is to do what we’ve always done – leverage research to analyze companies and deploy our ranking methodology to be selective in our investment approach. We do not add companies to portfolios based on trends or gut feelings. Each recommendation has a check and balance system where it is fully vetted by our investment committee before we buy or sell. I do not believe enough investors are being this deliberate with decision-making in the current market.
SPACs are a good example of risk taking that seems excessive in the current environment, in my view. Many readers have probably heard of the SPAC craze lately, so it is worth explaining briefly to you in my column. SPACs, also known as “blank check companies,” are essentially shell companies formed to raise enormous amounts of cash. SPACs raise the cash in order to then target and acquire companies—often start-ups with flashy new products and growth profiles—with the ultimate goal of taking the company public at windfall-generating valuations. Oftentimes, the companies that SPACs take public have no positive earnings or free cash flows yet.2
The appeal of SPACs is the same type of appeal that draws investors to the IPO markets: the possibility of fast, outsized returns gained from investing in a small start-up or a company with major growth potential. But on the other side of the SPAC coin is what investors should expect to encounter – very high risk and opaque information.
For one, start-ups and other companies that go public via SPACs don’t face the same constraints as traditional IPOs, particularly in the realm of financial disclosures and projections. For instance, companies that go public via SPACs often tout wildly positive growth expectations, but traditional IPOs would be sued by the federal government for doing the same thing. In this sense, investors often don’t know what they’re paying for, which I think is problematic.
Underscoring the depth of risk-taking, the pace of SPAC money-raising has far exceeded what we saw during the IPO boom in the late 1990s. SPAC issuance has been running at an approximately $28 billion monthly clip, while at the height of the dot-com bubble, it was more like $5 billion. There is a lot more liquidity in the current environment, but this to me is essentially the definition of froth.
I used SPACs as an example here, but the goal of my column this week is to remind investors to be cautious around any trend setting investment idea or asset class. Don’t get lured into the ‘get rich quick’ ideas of the moment. You can reach your long-term goals by focusing on quality and adhering to a disciplined approach like we do here at Zacks Investment Management. In the current environment, I believe research-based, fundamentally-driven investment ideas are as important as ever. That’s how we approach managing money.
Bottom Line for Investors
My goal here is to remind readers to take extra time to scrutinize what you invest in and know what valuation you’re paying for future cash flows. In some cases, a SPAC investment may mean investing in companies that have yet to generate positive cash flows. That’s not a very sound long-term strategy, in my view.
We manage client portfolios based on investment goals, and we drive our decision-making process based on research. The equity market is strong today, but there are pockets of froth building up in some areas and certainly in some ‘alternative’ asset classes, in my view. To me, that’s a clear indication to redouble focus on fundamentals and quality.