TD Bank’s $16.89 million bear notes on S&P 500 may likely be a win, contrarian says

By Emma Trincal

New York, Feb. 4 – Toronto-Dominion Bank’s $16.89 million of 0% bear Accelerated Return Notes due Feb. 24, 2023 linked to the S&P 500 index give investors a “fair chance” to reach the maximum return given the current market environment and the highly leveraged structure of the investment, said a contrarian portfolio manager.

If the index return is negative, the payout at maturity will be par of $10 plus 3% for every 1% that the index declines, subject to a maximum return of 22.5%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is positive, investors will lose 1% for every 1% that the index increases.

Sell high

“We don’t see those bear notes very often unless the market is down. That’s too bad. It would be better to price them when it’s high,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The S&P 500 index closed at 4,326.51 on the trade date, which was Jan. 27.

“The timing was a little bit off. The index hit an all-time high at 4,818.62 on Jan. 4. Then it dropped. When the notes priced at the end of the month, the market was already in correction mode,” he said.

When investing in a bear note, investors should capture a high entry point, not a low one, he explained.

“Unfortunately, the market has already moved up higher. It’s about 175 points above the value at which it was priced,” he said.

The benchmark closed at 4,500.03 on Friday.

“The timing is not perfect. But the structure is very favorable to investors who are rightfully concerned about this market bubble,” he said.

Kaplan, who has been bearish on the U.S. market for some time, said the 3x upside leverage gave investors a considerable advantage.

“The 22.5% cap is a reasonable rate of return for that period of time,” he said.

“You don’t even need a big drop to get your cap. The index is down 7% and you max out.”

“Even if the rebound rally persists a little, we’re not going to rebound much from where we are now.

“The high leverage gives you some latitude regarding the timing and the amplitude of the next market cycle.”

Concentration of risk

Kaplan expects a severe bear market, but his view is particularly negative on the United States.

“I like the idea of having a bear note on the S&P,” he said.

“Take the top seven stocks of the index, add them together and you get a 26.4% weighting. Apple itself is 7% of the index.”

Apple Inc is the index’s top holding. The six following ones are Microsoft Corp., Amazon.com Inc., Alphabet Inc., Meta Platforms Inc., Tesla Inc and Nvidia Corp.

“You get this dangerous concentration because the S&P is a market cap-weighted index. When some growth stocks become hugely overpriced, the result is a heavy weighting on a small number of names. And that’s a problem,” he said.

The index is also very concentrated by sectors, he noted. Nearly 30% of it is in technology and 22% in consumer discretionary and communication services, according to the S&P Dow Jones Indices website.

“People think they’re diversified when they buy the S&P. But that’s absolutely not the case. You are buying a small number of companies, which tend to be extremely overvalued,” he said.

Back to fundamentals

As a value-driven portfolio manager, Kaplan said the large-cap components of the S&P 500 index are overvalued based on the relationship between their price-earnings ratios and profit growth.

“Those stocks have P/Es that are much higher than their profit growth rates, sometimes twice or three times higher.

“You want growth to be greater than the price, not the other way around. That’s what you learn in the first week of business school,” he said.

“What drives the market are valuations, not earnings. If profit growth is far out of line with PE ratios in either direction then sooner or later there will be a regression toward the mean,” he said.

The greatest deviations from the mean will experience the “most violent moves” on the downside, he added.

Leveraging the leverage

Timing the burst of a bubble is not possible, he noted.

“You just don’t know exactly when it’s going to happen. No one knows.

“If the note was two or three years, we might have a better chance.

“This one is shorter, so it’s a riskier bet. But the 3x leverage helps a lot and offsets some of the risk because you really don’t need a big drop in the index to get a significant return.

“That’s a very good thing.”

The 22.5% maximum return over the 13-month period is the equivalent of a 20.7% annualized compounded return.

Such return can be achieved if the S&P 500 index returns 6.93% a year.

Past lessons

Kaplan expects the bear market to strike sooner than later.

“We hit an all-time high in Jan. 4. I think the chances to be down 7% in 13 months are quite reasonable.

“We can’t really forecast how soon we’ll see a severe drop. But some historical patterns exist, and they repeat themselves. Just look at 1929, 1972 or 1999. During those times, people paid no attention to valuations. Speculation was rampant. Large-cap growth stocks were hyper-valued. Very similar to what we’re in today,” he said.

Not a straight line

Timing the worst stage of the upcoming bear market is not even necessary for investors in the notes, he said.

The biggest asset price declines always happen at the beginning and at the end of a bear market, he noted.

In between, investors may get confused by robust bear rallies, but those do not last.

“At the end, panic rules and people start to sell like crazy. You get drastic losses at that stage and that’s when the next bull market begins.”

On average, a bear cycle lasts two years.

Given such average length and if one assumes that the S&P 500 index peaked at the start of the year, the notes are likely to mature before the bear market gets to its worst stage, he said.

“The 3x leverage gives you some wiggle room with the timing. It doesn’t matter if the notes mature at the worst stage of the bear market. You only need a modest price drop. So, your risk is really on the other side because if the market is up, there is no protection,” he said.

Investors in the notes need to have strong bearish conviction or alternatively should employ the notes as a hedge for the long positions in their portfolio.

“You could be wrong. It’s always a risk. But we are at all-time highs, and you don’t need a big price decline to win this bet. The odds are in your favor,” he said.

BofA Securities, Inc. is the agent.

The notes settled on Thursday.

The Cusip number is 891162760.

The fee is 1.5%.

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