Bitcoin, SPACs, and Short Squeezes: Mania in the Markets?

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Apr 15

Written By

By Sloan Smith, MBA, CAIA, CPWA® and Steven Fraley, MBA, CFA

Since the start of the Global COVID-19 pandemic we have seen historic events occur in the financial markets. Some of these incidents include the largest and quickest equity sell-off since the Great Depression, an economic stimulus package that equated to 50% of US GDP, historically low fixed income yields, and a rapid rebound in global equities. Along with these occurrences have emerged new trends that have led investors to question whether these are new opportunities or simply signs of market mania. The three areas that have generated the most intrigue are Bitcoin, Special Purpose Acquisition Companies (SPACs), and short squeezes. Each has been newsworthy and created some disruptions in the financial marketplace. However, their suitability for portfolios going forward needs to be carefully evaluated, including their potential risks and rewards.

Bitcoin

While Bitcoin has been around for over a decade, it has significantly gained in popularity over the last couple years. Bitcoin and cryptocurrencies are digital currencies that use cryptography to process transactions over a blockchain – a transparent digital ledger. The primary benefits of blockchain technology are reduced costs, increased security, enhanced transparency, and improved traceability. Another important factor in their popularity is that blockchains are decentralized, meaning banks and governments cannot manipulate their value like they can for traditional fiat currencies.

Like other disruptive technologies, the popularity and adoption of Bitcoin has increased significantly due to the COVID-19 pandemic. The fear of global economic turmoil created a perfect environment for the revival of cryptocurrencies, as global investors began viewing Bitcoin and other cryptocurrencies as alternatives to traditional asset classes. Like gold and other scarce assets, Bitcoin has a limited quantity in circulation, which can protect it against increased monetary supply. However, a major unknown with Bitcoin is how to determine its true value.

The jury is still out as to whether cryptocurrencies offer real world economic value. While there is no denying the increased attention and popularity of these decentralized financial instruments, many experts believe this could be another bubble in the making. It remains to be seen whether the continued adoption of cryptocurrency is here to stay or if it is just another “flash in the pan.”

Special Purpose Acquisition Companies (SPACs)

Historically, there have been two primary avenues for private companies to raise capital and list their shares on a public exchange. The most popular route has been through an initial public offering (IPO). The second major avenue has been through a direct listing of shares on a public exchange. A less well-known strategy is through a special purpose acquisition company (SPAC). This involves a company going public via a reverse merger, which is when a private company turns public by purchasing a publicly listed company.

The growth of SPACs has been in large part a direct result of the COVID-19 pandemic, which led to significant economic uncertainty. This environment made it difficult for companies to go public via more traditional routes, allowing the simplified process of a SPAC IPO to permit public listings to continue. There are three main parties involved in a SPAC: the sponsor, investors, and the target company. The sponsors are the creators of the SPAC and are incentivized by shares of the new public company, as well as the opportunity to provide strategic input and decision-making. Investors put their money behind a sponsor and management team in the hopes of finding an innovative company to provide strong returns on their capital. The final party is the private company or SPAC target. As fewer companies have gone public in recent years, reverse mergers have provided an attractive alternative to the more traditional methods. Reverse mergers have allowed companies to access public markets more quickly (i.e., in three to four months).

While SPACs have been enjoying increased popularity that may continue, they still represent a small portion of private companies looking to go public. As more clarity returns to the financial markets, we would expect the hype to settle down. Nonetheless, SPACs certainly have enough compelling features for them to remain a viable option going forward.

Short Squeezes

A short squeeze is when the price of a stock appreciates significantly due to a large number of short-sellers, or those betting against a particular stock, trying to cover their position. A short squeeze forces investors who had felt that a stock’s price would fall, to buy it back in order to prevent large losses. This item was front-page news after typically underwhelming equity names like Gamestop and AMC Theatres saw significant price appreciation over the course of a few trading days. Though these short squeezes may have at first seemed like a tremendous investment opportunity, there were also numerous concerns about the ability of these stocks to trade at such elevated levels.

These short squeezes were mainly driven by traders collaborating on Reddit, a social news aggregation and discussion website. The traders attempted to target large institutional funds (e.g., hedge funds) which held short positions in these particular stocks. Ultimately, the short squeezes in these stocks was short-lived, and the stock prices returned to more rational levels. These short squeezes serve to remind investors to avoid strategies that thrive on short-term mania and euphoria in the markets.

Conclusion

Bitcoin, SPACs, and short squeezes have all become popular topics in the financial markets, especially during the COVID-19 pandemic. Bitcoin and SPACs continue to evolve and may potentially be viewed as viable investments, but their volatility profiles remain very high. Short squeezes, on the other hand, are a trend that has created significant gains in some underappreciated stocks, but over the long term short squeezes are not a sustainable investment strategy. Each of these investment opportunities continue to evolve and require thoughtful and prudent due diligence. Their uncertainties and risks need to be carefully evaluated before determining if they have a potential place in a portfolio, including investors’ tolerance for substantial volatility.