Are Soaring SPACs Signaling a Stock Market Blowout?

The stock market ended the holiday-shortened Christmas week with a solid gain, leaving the Nasdaq Composite (^IXIC -0.39%) at record levels and helping the S&P 500 (^GSPC -0.74%) and Dow Jones Industrial Average (^DJI -1.53%) add to their returns for 2020. With just a week to go before the end of the year, U.S. markets are on pace to post a big win.

Data source: Yahoo! Finance.

Many have been amazed at just how well the stock market has done this year, especially given all the challenges from the COVID-19 pandemic. One source of big gains has been the market for special purpose acquisition companies, or SPACs.

Even today, SPACs were among the biggest winners, and the share-price rises that investors have seen don't always seem to come for very good reasons. Below, we'll look at whether investors should worry about how special purpose acquisition companies are doing and what it might mean for the broader stock market.

SPACs have been soaring into the sky, but will they fall back to Earth? Image source: Getty Images.

Big gains for SPACs on Thursday

Nowadays, it seems as though SPACs routinely show up on the list of top performers in the stock market. Today was no exception:

• RMG Acquisition (RMG) soared 19%, as the SPAC's shareholders prepare to meet next Monday, Dec. 28, to approve its proposed transaction with the parent company of lithium-ion battery-pack specialist Romeo Power Technology.
• Bridgetown Holdings (BTWN) picked up 12% on speculation that the Peter Thiel-backed SPAC might choose to merge with Indonesian e-commerce start-up Tokopedia.
• Thunder Bridge Acquisition II (THBR) rose more than 7%, carrying momentum from its announcement last week that it would merge with automotive chipmaker and software company Indie Semiconductor.

Across the market, interest in SPACs has been at a fevered pace lately. There's no shortage of SPACs still searching for smart acquisition candidates, and more special purpose acquisition companies come public every day to try to claim their share of the deal flow.

Every move you make, investors are watching you

Yet there's a troubling trend in the SPAC world that suggests investors don't really understand everything about how they work. Consider a few examples.

First, SPACs routinely see their share prices rise after shareholders vote to approve previously announced mergers. Yet that's not really new news, because if the SPAC share price is above the initial SPAC offering price -- usually $10 per share -- then it's a foregone conclusion that investors like the deal and it'll get approved.

Second, many SPACs rise once they change their ticker symbols to reflect the name of the acquired target company. That's silly, since there's no economic substance to that change at all. Yet it suggests that many investors don't think they can buy the SPAC until deals are complete -- and those investors often miss out on getting a more favorable buying price.

Finally, many investors don't understand the interplay of SPAC shares, warrants, and units. Often, you can trade in all three of these instruments with any single SPAC -- but their prices don't always move in lockstep.

Be smart with SPACs

Investing in a SPAC once it finds a merger candidate is like investing in a company before it fully comes public. Investing in a SPAC before it finds a target company is a bet on the SPAC managers to find a suitable acquisition.

The only truly important pieces of news for a SPAC are when it makes an agreement with a target and closes on that deal. Everything else is typically just noise. The fact that SPAC investors are going wild over so many pieces of insignificant news releases is a troubling sign of froth in the stock market. Smart SPAC investors will be careful to choose the best prospects for their investment capital.