Morgan Stanley’s dual directional notes on Technology Select are well-timed, contrarian says

By Emma Trincal

New York, April 21 – Morgan Stanley Finance LLC’s 0% bearish dual directional trigger participation notes due April 29, 2024 linked to the Technology Select Sector SPDR fund offer the right timing and underlying for a bearish bet, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

If the final ETF price is less than the initial price, the payout will be par plus the absolute value of the price decline up to a cap of par plus 30%, according to an FWP filing with the Securities and Exchange Commission.

If the final ETF level is greater than or equal to the initial price, but less than the 120% trigger level, the payout will be par plus the return of the fund.

If the final ETF level is greater than the trigger level, investors will lose 1% for each 1% of prince increase from the initial level.

Concentration

“This note comes at the right time,” said Kaplan.

“The 30% cap on the downside might not even be high enough. This ETF is kind of a who’s who of overvalued companies. Perhaps the worst part is its concentration since it’s market cap-weighted.

Apple and Microsoft, the top two names out of 66 holdings, together represent 47% of the fund, he observed.

“Add Nvidia and the top three holdings make for more than half of the entire fund,” he said.

All three tech stocks are trading three times their fair value, he noted.

“It means their price is triple their earnings growth. It’s totally unbalanced. To change that, the rate of profit growth would have to triple to be in line with the fair value. This is not going to happen with those tech behemoths. Alternatively, the P/E would have to go down, in which case the stock price will go down.”

That second scenario was the likely one, he predicted.

Uncharted territory

Kaplan said that the current bubble is unique.

“We have never seen such high valuations in the past. When price is triple the profit growth, you’re in a very dangerous situation,” he said.

Even in 1929 or 2000 valuations were not as high, he noted. The 2007-08 bear market was different in that it was not driven by excessive valuations.

“This situation is a rarity and it’s not a good rarity,” he said.

In the past, overvalued stocks were trading double, not triple fair value, he added.

Another sign the market is in a “dangerous” bubble could be measured by the number of stocks pricing at those record highs, which occurred in 2021, 2022 and 2023 so far.

“We haven’t seen those valuations before. This is why it’s inevitable that the market will drop even more than it has last year. I expect the market to be down more than 30% in 2023, in fact, it could easily drop more than 40%,” he said.

Money flows

For a very bearish investor, the notes may cap the return too soon.

But timing the amount of a market decline over one year is highly unpredictable, he said.

“I could be wrong in my prediction. The market may not drop 30% to 40% this year. or if it does drop that much, it could bounce a lot. You may end up with a 25% drop for the year, in which case your 30% cap is fine,” he said.

Another bearish sign was the recent inflow of capital into stocks.

“We hear a lot about people moving their deposits out of the regional banks into the big banks. But the amount of inflows into the big banks is not as large as the outflows. The rest of the exodus has moved into the stock market. Not into Treasuries despite their safety. But into overvalued, overbought tech stocks.”

The Technology Select Sector SPDR fund has gained 31% from its October low of 112.97. Since the beginning of March, it rose nearly 10%.

Barrier

The “upside,” which is the area where one can get a positive return before losing principal if the fund appreciates above 120% may satisfy a more “skeptical” type of investor, he said.

For Kaplan, whose bearish conviction is strong, the barrier was unnecessary.

“I’m pretty sure that XLK is not going to finish up 20% one year from now,” he said referring to the ticker of the underlying.

“There is no way. Not with half of the fund in Apple, Microsoft and Nvidia.”

But the use of a barrier was usually helpful.

“For someone who is not totally sure, it’s reassuring. And being able to make money in both directions gives peace of mind,” he said.

Kaplan said his view is more bearish, disclosing that he is short the Technology Select Sector SPDR ETF.

“I’d rather see an extended cap on the downside because I don’t think I’m going to need the 20% barrier,” he said.

The right pick

Kaplan is also short the Invesco QQQ ETF, which tracks the Nasdaq-100 index. But he said that the Technology Select Sector SPDR ETF was even worse.

“They couldn’t have picked a worse fund. XLK is more concentrated with 66 stocks versus 101 for QQQ. But XLK is worse because it has more semiconductor exposure than QQQ and those are the most overvalued stocks.

“I should say they couldn’t have picked a better fund to bet against,” he said.

The notes are guaranteed by Morgan Stanley.

The notes were expected to price on April 21 and to settle on April 26.

The Cusip number is 61774XRZ8.

Morgan Stanley & Co. LLC is the agent.

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