Wealth Planning Archives | Page 18 of 21

Reasons for optimism as prices, bond yields rise

As we move closer to summertime, the pace of economic growth remains robust. Much of the strength of the U.S. economy can be attributed to the fiscal aid that has been injected through several rounds of stimulus. The recent boom in spending has stirred up fears of economic overheating and of potential longer-term inflation.

While prices generally have increased, metrics like the Consumer Price Index (CPI) are measured relative to the prior year, and a year ago was when the economy was broadly shut down. As seen in the chart below, the stock market (viewed by the S&P 500) reacts favorably as inflation expectations rise. In the past, sustained inflationary pressure has come from a severe tightening in the labor market. We are nowhere near a labor market crunch, as there are still millions of jobs that have not been recovered from the pandemic.

Europe’s economy finally is turning the corner, leaving its double-dip recession behind. Lockdowns, slow vaccine rollouts and delayed fiscal stimulus have hindered its recovery, but Europe is at an inflection point, and the rollout of its largest-ever stimulus plan should aid economic growth. First-quarter earnings in Europe outpaced those in the U.S. for the first time in years, another positive signal for European markets.

*EM = Emerging Markets; EPS = Earnings per Share*

The global recovery should pick up in the second half of the year as widespread vaccinations allow more economies to reopen. The demand for U.S. Treasury bonds has helped keep a lid on rising Treasury yields, which are higher than those in Japan and Europe. If global growth picks up as expected in the second half of the year, bond yields in other countries may move higher, along with U.S bond yields.

So, what can we learn from all this? Higher bond yields and inflationary pressures are not a reason to panic. Over the last 20 years, the S&P 500 has produced an average annual return of close to 6%. Optimism in the stock market remains elevated, even with the recent sell-off in the market and increased inflation concerns. We continue to adhere to the tried-and-true disciplines of diversification, periodic rebalancing and looking forward, not making investment decisions based on where we have been. Making market decisions based on what might happen may be detrimental to long-term performance. The key is to stay invested and stick with the financial plan. Markets go up and down over time, and downturns present opportunities to purchase stocks at a lower value.

It all starts with a solid financial plan for the long run that understands the level of risk that is acceptable for each client. We believe in diversification and having different asset classes that allow you to stay invested. The best option is to stick with a broadly diversified portfolio that can help you to achieve your own specific financial goals — regardless of market volatility. Long-term fundamentals are what matter.

Sources: Bloomberg, Schwab, CNBC

This material contains an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources.

Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.

Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment Advisory Services offered through Kestra Advisory Services, LLC (Kestra AS) an affiliate of Kestra IS. Kestra IS and Kestra AS are not affiliated with CD Wealth Management. Investor Disclosures: https://bit.ly/KF-Disclosures

Why today’s inflation is different from the 1970s

We have grown accustomed to years of low inflation and lower prices for goods and services, but raw materials, semiconductors and labor now seem to be in short supply. (Anyone doing home construction knows this all too well.)

In simple terms, prices are determined by the laws of supply and demand. If demand is low and supply is high, the prices you pay for goods and services are lower. However, if demand is high and supply is low, prices will rise to meet the demand — until the supply can catch up. As the chart shows, if you have a lower quantity of goods and a higher demand for them, retailers can charge a higher price. At higher prices, buyers will begin to demand less of an economic good, and at the same time, sellers will supply more goods for additional revenue. As the supply of goods increases, prices will fall to find an equilibrium between supply and demand. When the supply of goods outpaces demand, prices drop even further.

Remember, multiple factors may affect supply and demand, causing them to increase or decrease in various ways. For example, in Texas and other parts of the country, we are seeing a housing shortage. There is a lack of supply and a strong demand for homes, as people moved to Texas from California and New York in record numbers since the pandemic began. Restaurant prices are higher as commodity prices have risen due to scarcity. Trucking companies are having a hard time attracting new drivers, so they are paying higher salaries, and cost increases are passed on down the line. These are just a few examples that are causing higher, temporary inflationary pressures.

Federal Reserve Chair Jerome Powell says the Fed expects near-term pricing pressures to diminish as supply bottlenecks are resolved and as sharp price declines from the pandemic fade from inflation calculations. The New York Fed’s recent monthly survey of consumer expectations also suggests that many expect the inflation bump to be short-lived.

In the 1970s, President Jimmy Carter took office during a period of stagflation, which occurs when there is high inflation and low economic growth. Several factors are in play today that were not happening during the high inflation of the 1970s:

* Central bank stimulus: Central banks in the ’70s reacted to high inflation by tightening the monetary supply. Today’s response is the opposite, with an increased money supply.

* Fiscal stimulus: We have seen unprecedented fiscal stimulus domestically and abroad. These programs help support business, consumer and investor confidence.

* Capital spending: Supply constraints that exist today may lead to additional capital investment by businesses, especially in semiconductor manufacturing.

* Service sector rebound: As the world economy continues to rebound from the global pandemic, and with Europe and Asia behind the U.S. in the reopen trade, the service sector’s reopening may offset manufacturing weakness.

So, what can we learn from all this? While the current environment does have some resemblance to the 1970s, the differences are probably strong enough to keep investors focused on the positives: reflation driven by solid growth accompanied with inflation, rather than higher prices with slower growth. Optimism in the stock market remains elevated, even with the recent sell-off in the market. We continue to adhere to the tried-and-true disciplines of diversification, periodic rebalancing and looking forward, not making investment decisions based on where we have been. Making market decisions based on what might happen may be detrimental to long-term performance. In the case of potential tax on capital gains or personal tax hikes, the S&P 500 has historically performed well in years of tax increases. The key is to stay invested and stick with the financial plan. Markets go up and down over time, and downturns present opportunities to purchase stocks at a lower value.

Given the difficulty of timing the market, the most realistic strategy for a majority of investors is to invest and stay invested over time. Procrastination, or not investing, is worse than bad timing. We continue to view more risk being out of the market than in the market. Riding out future market volatility, in addition to having a diversified portfolio, means staying the course. From an investment perspective, we use trends to help with the strategic and tactical asset allocation and where we see the portfolio heading over the next 5-7 years with short-term adjustments along the way.

It all starts with a solid financial plan for the long run that understands the level of risk that is acceptable for each client. With regards to investments, we believe in diversification and having different asset classes that allow you to stay invested. The best option is to stick with a broadly diversified portfolio that can help you to achieve your own specific financial goals — regardless of market volatility. Long-term fundamentals are what matter.

Sources: Schwab, Lucidchart, The Wall Street Journal

Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

What would Biden’s tax increases mean for the markets?

Last week, rumors began to swirl about the Biden administration’s proposal for increasing tax rates for the richest Americans from 37% to 39.6% and raising the capital gains tax on people earning more than $1 million from 20% to 39.6%. There is still a long way to go before we see any tax hikes, and as is often the case, the initial market reaction is to sell upon hearing the news. Markets have produced better-than-average returns during past tax increases, as other economic factors are happening that may influence subsequent market behavior. Going back to 1968, there is only a minimal correlation between changes in the capital gains tax rate and market returns, as seen in the chart below.

The next chart further illustrates the point that the market selling last week on the news of potential higher tax rates may be overblown. Since 1950, only one instance of negative market returns in the S&P 500 occurred when taxes were increased. Taxes break down into three buckets: corporate, personal and capital gains. Big tax increases are rare, and only once since 1970 have all three been increased at the same time. (That happened in 1993.) Democrats have slim margins in both houses of Congress, and it is still to be determined how much of the higher tax rate agenda will make it into law. It will take time for Congress to negotiate a major package, and it’s possible that if rates are increased, it may not happen until 2022.

In years with tax increases, the average S&P 500 return since 1950 has been 9%. However, changes to the tax code do not happen in a vacuum; normally, there are other actions in Congress and the economy. As we are seeing today, significant stimulus spending by the government and action from the Federal Reserve following the pandemic shutdowns also may contribute to higher-than-average returns, even when taxes are being raised.

So, what can we learn from all this? Making market decisions based on conjecture of what might happen may be detrimental to long-term performance. The S&P 500 historically has performed well in years of tax increases. The key is to stay invested and stick with the financial plan. Markets go up and down over time, and downturns present opportunities to purchase stocks at a lower value.

Sources: Factset, UBS, Fidelity

Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

Even with inflation, the global economy’s on a roll

We have now experienced the sharpest “V-shaped” economic recovery in history — a deep global recession and rapid recovery within five quarters. A combination of vaccine rollouts and worldwide fiscal stimulus led to global growth forecast of 6% for 2021, and the U.S. GDP forecast is anywhere between 6% and 8%, which would be the fastest pace of growth since 1983.

We continue to see reacceleration in the job market, as nonfarm payrolls for the month of March grew by 916,000 jobs, and they are being added in nearly every sector, which is a strong positive for the overall economy. The downside is that we are still nearly 8.5 million jobs behind pre-pandemic levels of employment.

Inflation remains the talk of the town (and all the news channels). The consumer price index (CPI) has surged, but given that it is measured year-over-year, we are now comparing the current strong gains to depressed prices and demand from this time last year.

Inflation is rising around the world, lifted by transitory factors and supply-chain bottlenecks. With delays in ports and limited access to supply, prices are bound to rise near term. However, as shortages begin to disappear and supply delivery times shorten, inflation is expected to ease and land within a comfortable zone for world economies.

We are now in earnings season on Wall Street. Last year, we saw a surge in stock prices while earnings plunged as large pockets of the economy were shuttered. The effect of this is a growing Price-to-Earnings multiple (P/E) of the S&P 500. At the end of last year, the P/E multiple hit 27, a valuation in line with the late 1990s. With the growth in earnings in the current and previous quarters, the P/E multiple for the S&P 500 is roughly 23, which remains above average. Regardless of whether the P/E is above or below average — cheap or expensive — it is important to know that valuation based on P/E multiples is not an effective market timing tool. Markets can become expensive and stay expensive for some time without a negative impact on stock prices, especially if momentum and positive investor sentiment, like we are seeing today, are the dominant drivers.

So, what can we learn from all this? The global economy is on a roll. With strong earnings growth, increasing labor force and vaccine rollouts, all signs point toward tremendous GDP growth. Nonetheless, risks remain in the global market. Having a diversified portfolio and a mix of equities provides discipline around risk mitigation. Markets go up and down over time. The key is to stay invested and stick with the financial plan. Market downturns present opportunities to purchase stocks that were previously viewed as overvalued. In a down market, you are “buying low,” one of the fundamental tenets of investing.

Sources: Bloomberg, Federal Reserve Bank of St. Louis, Schwab

Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

Economic optimism — and the case for diversification

The economic outlook for the second quarter of 2021 is overwhelmingly optimistic. With stimulus checks, market performance, increasing numbers of vaccinations and even the improving weather, the optimism is real! Bolstered by an unprecedented third round of stimulus payments, consumers appear to be on a spending spree. As the economy continues to reopen around the globe, spending on goods and services is ramping up. The chart below illustrates an increase in consumer usage of credit cards at a physical location. While not quite back to pre-pandemic levels, consumers are using their credit cards at the point of sale at a rapidly rising pace.

Because stocks are a leading indicator of the economy, it typically is the case that economic data lags behind market performance. Market peaks have generally proceeded recessions, and market dips generally have preceded economic recoveries. The table below shows that in the post-WWII era, there has been only one exception to a bear market starting before a recession (2000-2002). In all other cases, the bear market started before the recession, and the bear market ended before the recession ended. It has been an extraordinary run for stocks since the short-lived COVID-19 bear market ended in March 2020.

Equity market fundamentals confirm current optimism in the market. The consensus projection for S&P 500 revenue this year is a 9% increase, and earnings per share is expected to increase by 21%. With the Federal Reserve planning to keep rates low and longer-term interest rates moving up, this has led to value stocks outperforming growth stocks to start the year. The large-cap tech stocks remain near August levels, but we are seeing a broadening out of the market leaders — another positive for the stock market. The periodic table below shows the different sectors of the S&P 500 and their monthly returns over the last year. This chart makes another case for the importance of diversification in equities.

So, what can we learn from all this? Picking the right sector or the right fund is challenging in any market — but having a diversified portfolio and mix of equities provides equity exposure in good times and bad. Markets go up and down over time. The key is to stay invested and stick with the financial plan. Market downturns present opportunities to purchase stocks that were previously viewed as overvalued. In a down market, you are “buying low,” one of the fundamental tenets of investing.

Sources: JPMorgan, Bloomberg, Schwab

Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

Positive momentum, economic expansion and rising business confidence

The markets continue to climb, lifted by positive economic data, such as manufacturing, homebuilding and increased employment. As vaccines become more widespread and the public begins to venture out, businesses will continue to reopen, and their capacity will expand. All signs point toward a strong GDP in 2021 as fiscal and monetary stimuli pump an unprecedented amount of liquidity into the economy.

The improving business confidence may translate into strong capital goods shipments as well, and hiring is picking up, as seen by the March job numbers. Restaurants will continue to add capacity, as will the airline and hospitality industries. Positive momentum for the global economy widens the range of outcomes for how strong our GDP may be in 2021.

Earnings, interest rates and inflation are three ingredients that will help determine the trajectory of stock prices over the next several years. Earnings expectations continue to remain a bright spot for the stock market. The expectations for 2021 earnings on the S&P 500 are 26% higher than in 2020; these estimates continue to rise, and projections may move even higher. The Fed has made it clear that interest rates will remain low through 2022, even though the 10-year and 30-year Treasury rates may continue to move higher. Stocks have been relatively unfazed with the rise in the 10-year Treasury bond.

The first quarter in the stock market did see sector rotation taking place, as seen in the chart below. Large-cap growth stocks finished the quarter basically flat, while value stocks outperformed. The sectors that have been leading the last few years, such as information technology and consumer discretionary, lagged in the first quarter, while energy and financials were strong performers. One could argue that these sectors were due for a break after the tremendous run the last two years, but rising rates also were a factor.

It is natural to be apprehensive about the market, given the current levels. Skepticism and caution can lead to focusing on near-term issues, instead of concentrating on the endgame. Economic expansions since World War II have lasted 26 quarters on average, with the shortest expansion being 11 quarters and the longest 48 quarters. The current cycle is only five quarters old. During expansions, markets may take a breather and have a correction, but keeping an eye on the long term remains the best approach.

Sources: Factset, Smith Asset Management

Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

What’s the cost of missing the market’s best days?

Timing the market is extremely difficult – even during the best of times and for the top traders on Wall Street. A recent study by Bank of America shows that if an investor missed the S&P 500’s 10 best days each decade going back to 1930, the total return for the entire 80+ years would be 28%. On the other hand, if that same person had stayed invested, the total return would have been 17,715%!

A chart showing investment returns since 1930 and the impact of missing the market's best and worst days each decade.

When stock markets have a sell-off, the natural impulse for many investors is to hit the sell button. However, the best market days, in regard to performance, often follow the biggest drops. If you follow your impulse to sell, your returns could end up closer to 28% over 80 years versus the much larger return from staying invested through both good and bad days.

As the chart below shows, April has historically been one of the best months for the stock market since 1964. The average monthly return has been 1.7%, and the market has been positive almost 75% of the time. More importantly, every month except for September has had positive return more than 50% of the time over the last 56 years.

Chart showing average monthly returns for the S&P 500 from 1964 to 2020.

So, what can we learn from all this? Markets go up and down over time. The key is to stay invested and stick with the financial plan. Market downturns present opportunities to purchase stocks that were previously viewed as overvalued. In a down market, you are “buying low,” one of the fundamental tenets of investing.

Given the difficulty of timing the market, the most realistic strategy for a majority of investors is to invest and stay invested over time. Procrastination, or not investing, is worse than bad timing. We continue to view more risk being out of the market than in the market. Riding out future market volatility, in addition to having a diversified portfolio, means staying the course. From an investment perspective, we use trends to help with the strategic and tactical asset allocation and where we see the portfolio heading over the next 5-7 years with short-term adjustments along the way.

It all starts with a solid financial plan for the long run that understands the level of risk that is acceptable for each client. With regards to investments, we believe in diversification and having different asset classes that allow you to stay invested. The best option is to stick with a broadly diversified portfolio that can help you to achieve your own specific financial goals — regardless of market volatility. Long-term fundamentals are what matter.

Sources: CNBC, Topdowncharts

Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

What portfolio changes are we making as the first quarter ends?

As we near the end of the first quarter of 2021, we’d like to review where we’ve been and let you know where we are headed with the portfolio. The year started the same way 2020 ended: with the stock market continuing its upward momentum, led by large-cap stocks — specifically, technology companies. Then Bitcoin caught the public’s attention, as did GameStop mania. The 10-year Treasury has increased from 0.9% to 1.6%, and the NASDAQ experienced a correction, albeit a very brief one.

We are in the process of reallocating and rebalancing the portfolios to account for the economic recovery and the economic lifecycle of the U.S. and the world. We are making the following changes:

1. After increasing our technology position in 2020 to align the portfolio with the technological boom that resulted from the pandemic, we are reducing our exposure in technology to a market-weight level. Looking at the long term, we continue to believe strongly in the technology sector and will continue to have a strong weighting. As more people have access to the vaccine, however, the economy continues to reopen and broaden. Travel is increasing, people are eating out more, and stocks that were out of favor last year are becoming more relevant this year.

2. International equities remain less expensive on a price-to-earnings multiple basis, compared to the U.S. stock market, and we are adding to our current position. We believe that small- and mid-cap stocks will benefit from the economic reopening, and we are increasing our current allocation. At the same time, we are increasing our allocation to higher dividend-yielding companies that have a broad exposure to the overall economy in sectors like financials, energy and industrials.

3. From a fixed-income perspective, we are reducing our current weighting in high-quality corporate bonds and adding a strategic income fund that provides diversification to different asset classes within fixed income. As interest rates rise, certain fixed-income segments invest in bonds that rise with higher rates and provide increased flexibility within the portfolio.

Our focus remains on long-term investing with a strategic allocation while maintaining a tactical approach. Our decisions to make changes are calculated and well thought-out, looking at where the economy is heading. We are not guessing or timing the market. We are anticipating and moving to those areas of strength in the economy and in the stock market.

We strategically have new cash on the sidelines and buy in for those clients on down days or dips in the market – like one does in a 401K every other week. We speak with our clients regularly about staying the course and not listening to the economic noise.

In the short term, the outlook for the global economy continues to improve – specifically, with the recent passage of a $1.9 trillion stimulus package and millions receiving their vaccinations. The Federal Reserve has stated on many occasions that it plans to allow mild inflation to increase and reach above 2% for the foreseeable future — and it is unlikely to raise short-term interest rates in the near future.

So, what can we learn from all this? From an investment perspective, we use these trends to help with the strategic and tactical asset allocation and where we see the portfolio heading over the next 5-7 years, with short-term adjustments along the way. We are not trying to time the market. We continue to view more risk being out of the market than in the market. Riding out future market volatility in addition to having a diversified portfolio means staying the course.

It all starts with a solid financial plan for the long run that understands the level of risk that is acceptable for each client. With regards to investments, we believe in diversification and having different asset classes that allow you to stay invested. The best option is to stick with a broadly diversified portfolio that can help you to achieve your own specific financial goals – regardless of market volatility. Long-term fundamentals are what matter.

Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

What does the recent surge in Treasury bonds mean?

The spike in U.S. Treasury bonds last week sent a small sell-off through the global markets. The 10-year Treasury yields surged to their highest level in more than a year, as seen in the chart below. The bond market is forecasting that higher economic growth is likely to occur this year with the rollout of vaccines and additional fiscal stimulus, and the Federal Reserve has stated on many occasions that it plans to let inflation run above 2% for an extended period of time.

With the likelihood of another stimulus package coming in March, we will be watching the money supply, which historically has been a leading indicator for the economy. The M2 money supply — the amount of currency, deposits and money in checking accounts, plus retail money market fund balances and savings deposits — has grown at a rate of 25% over the past year and is at its highest rate since 1960. COVID relief acts in 2020 explain this rapid growth; as stimulus checks have been mailed to households, checking and savings account balances increased over the last year. Some of the money has been spent and has flowed through the economy, but most has been saved. The unspent money will eventually find its way into the economy and the markets.

In recent weeks, the primary driver of the 10-year Treasury’s surge has been the rising expectation of inflation from this excess money supply. However, it is not a foregone conclusion that long-term rates are on a higher trajectory. As seen in the chart below, recessions like we had in 2020 have typically been followed by low interest rates several quarters later. For example, in 2008, the 10-year Treasury bond was at 2%, and in 2012, as the economy recovered, the rate rose to 4%, only to hit 1.4%.

The Federal Reserve has many tools at its disposal to fight the rise in long-term rates, including the ability to ease investors’ worries about higher rates through communication. The Fed can continue to purchase bonds in the open market or even increase the amount of bonds it is buying to push rates or drive yields lower. It is important to remember that over the long run, higher yields driven by strong economic growth are a positive for the markets.

So, what can we learn from all this? Markets are concerned that the Fed might rush to raise short-term interest rates in the face of stronger inflation data. The recent rise in the 10-year Treasury yields was driven more by prospects for stronger economic growth than inflation. With the real yield still in negative territory (taking inflation into account), there is plenty of room for the 10-year Treasury to return to normal if the economy’s prospects continue to improve as expected.

We use the above insights to help with the strategic and tactical asset allocation based on where we see the portfolio heading over the next five to seven years, with short-term adjustments along the way. We are not trying to time the market, but we will try to take advantage when we see where the stock and bond market heading. Having a well-balanced, diversified, liquid portfolio and a financial plan are keys to successful investing. The best option is to stick with a broadly diversified portfolio that can help you achieve your own specific financial goals – regardless of market volatility. Long-term fundamentals are what matter.

Sources: Guggenheim, Bloomberg, Charles Schwab

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Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

The MSCI Europe Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI AC (All Country) Asia ex Japan Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of Asia, excluding Japan. The Dow Jones Industrial Average is a popular indicator of the stock market based on the average closing prices of 30 active U.S. stocks representative of the overall economy.

S&P 500 Index is an unmanaged group of securities considered to be representative of the stock market in general. NASDAQ Composite Index measures all NASDAQ domestic and international based common type stocks listed on The NASDAQ Stock Market. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It is not possible to invest directly in an index.

Click Here for Additional Investor Disclosures

What is a SPAC? A popular investment trend explained

Investors often get excited when they learn that a private company they’re following is planning an initial public offering, and last year’s IPO momentum carried over into 2021. Nasdaq saw 91 IPOs in January alone, and more than two-thirds were special-purpose acquisition companies (SPACs), one of Wall Street’s hottest trends.

What exactly is a SPAC — and how does it work? A SPAC is set up with no commercial operations of its own; it is formed only to raise capital for the purpose of acquiring an existing private company. SPACs have been around for decades, as seen in the chart below, but they have recently gained popularity as a medium for smaller, private companies to go public. Examples of companies recently going through a SPAC merger are DraftKings, Virgin Galactic, Opendoor and Nikola, to name a few.

SPACs make no products and do not sell anything. The only asset a SPAC has is the money it raises through an IPO. Institutional investors (or very wealthy investors) typically create SPACs, which often are referred to as “blank check companies” because when they raise money, investors do not know what the eventual acquisition target will be. By design, SPACs have a specific period of time — normally two years — to identify a suitable company to acquire.

SPACs are not allowed to prescreen investments or sign letters of intent prior to going public or raising monies. The money raised in the IPO is placed in an interest-bearing trust account, and funds cannot be dispersed except to complete an acquisition or to be returned to investors if the SPAC is liquidated because it could not close a deal quickly enough.

If a company agrees to be acquired by a SPAC, it will forgo the IPO process during the two-year open period. Investors, therefore, receive immediate liquidity and equity exposure via the SPAC. Assuming SPAC shareholders approve the merger, the SPAC’s name changes to the name of the acquired company when the purchase is complete.

What can go wrong with investing in a SPAC? Not every SPAC completes all the phases in the chart above within the two-year window. Target companies run the risk of having their acquisition rejected by SPAC shareholders. SPAC investors are putting money blindly into an investment vehicle, not knowing what company may be acquired with their investment. The due diligence process of the SPAC is not as thorough as that of the IPO process, and therefore, can be riskier.

There are no guarantees that SPAC returns will not fall short of the average post-market return. Most SPAC investors are not buying at the SPAC’s IPO price, usually $10 per share. Instead, they often buy shares on the open market, with a considerable premium added. If the SPAC is unable to close a merger, it returns $10 per share to the investor, possibly far less than what the investor paid.

So, what can we learn from all this? SPACs can be a good investment vehicle. However, investors need to understand the risks involved and the hidden danger of paying a premium price while not knowing what company they may end up acquiring. Investors should invest only as much as they are willing to lose, and if one does invest, it should be part of a well-diversified portfolio.

From an investment perspective, we use the above insights to help with the strategic and tactical asset allocation based on where we see the portfolio heading over the next five to seven years, with short-term adjustments along the way. We are not trying to time the market, but we will try to take advantage when we see where the market is heading. Having a well-balanced, diversified, liquid portfolio and a financial plan are keys to successful investing. The best option is to stick with a broadly diversified portfolio that can help you to achieve your own specific financial goals – regardless of market volatility. Long-term fundamentals are what matter.

Sources: CNBC, Wealthmanagement.com, Credit Suisse

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Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Past performance is not a guarantee of future results.

Click Here for Additional Investor Disclosures