Bubble peak makes Scotia’s $5.6 million notes on Energy Select too risky, contrarian says

By Emma Trincal

New York, Oct. 20 – Bank of Nova Scotia’s $5.6 million of 0% capped buffered enhanced participation notes due April 18, 2025 linked to the Energy Select Sector SPDR fund put investors at risk given the extended valuation of the energy sector, which is in bubble territory, warned Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

If the final ETF level is greater than the initial level, the payout at maturity will be par plus 300% of the ETF return, subject to a maximum settlement amount of $1,314.10 per $1,000 principal amount of notes, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the ETF finishes flat or falls by up to 10% and will lose 1.1111% for each 1% ETF decline beyond 10%.

Bottom to peak

“The energy bubble is not as well-known as the AI bubble, but it’s just as much of or even more of a bubble if you look at the way prices have gone up from bottom to top,” he said.

Kaplan compared the Energy Select Sector fund (Ticker: “XLE”) with the Invesco QQQ Trust (Ticker: “QQQ”), which tracks the Nasdaq-100 index.

“From its low in March 2020 to its top in November 2021, QQQ increased by nearly 148%. But from March 2020 when XLE also bottomed to its high in November 2022, XLE jumped 314%. From bottom to peak, it quadrupled in price, and it rose twice as much as QQQ,” he said.

The Energy Select Sector SPDR ETF is composed of the stocks of large oil companies, such as Exxon Mobil Corp., Chevron Corp. and Schlumberger Ltd.

“Profits of the big oil companies in XLE haven’t gone up as much as their price. The valuations are way out of line,” he said.

“The sector is clearly in bubble territory,” he said.

Depressed, very high

Volatility was also a concern.

At the onset of the Covid-19 pandemic in March 2020, the ETF price plummeted, scoring its lowest level in 20 years.

“XLE was more depressed than the overall stock market,” he said.

The low share price prompted intense insider buying, which hit a record at the time.

But the bear market was short-lived, and very soon, energy stocks began to rally.

“The 2020-21 recovery was spectacular and in the overall market too. But XLE jumped much more in percentage points because its price was already so depressed,” he said.

In 2022, the stock market fell into bear market territory, but the energy sector remained strongly bullish.

“When stocks and bonds were down in 2022, energy was the only sector to be up,” he said.

And up it was. The Energy Select Sector fund in November 2022 had gained 70% for the calendar year, scoring its second highest level since 2014 at $94.71.

“The price went up like crazy. It was a very crowded trade. Naturally insiders of the top holdings in the fund began to sell massively. Last November, insider selling hit an all-time high,” he said.

Insider transactions don’t really impact prices, he said. But they’re a valuable indicator.

“They show what intelligent investors are doing,” he said.

Stocks first, energy next

Kaplan pointed to an “interesting historical pattern” he observed between the overall equity market and energy shares, which he uses in his analysis.

“Typically, energy share prices tend to peak later than the stock market, around one year later,” he said.

He mentioned the 2000-21 and 2007-08 periods, which in both cases saw the stock market peaking a year before the energy sector.

The most recent case, although not exactly showing a year lag, was the peak of the S&P 500 index in January 2022 followed by the high of the Energy Select Sector in November 2022.

“It’s not always exactly one year. But it’s usually around that length of time,” he said.

A more representative demonstration of this pattern was the interval between the top of QQQ in November 2021 and the high of the energy ETF, exactly a year later.

No breakout

Technical analysis confirmed Kaplan’s bearish take. The ETF has not been able to retest its November high of a year ago, he said.

“It came very close. In fact, it hit an intraday high of $92.56 on Thursday,” he said.

But there is still no breakout above the $94.71 high.

Higher oil prices have not helped as they should have.

“Even though energy companies benefit from additional gains, XLE is not making new highs. It looks like the commodity rally is already baked into the share price of XLE,” he said.

Unjustified price

Finally, the fundamentals also support the notion of a possible reversal.

“Energy is a popular and overbought sector play. It’s a huge bubble. Too many people are buying without paying any attention to profitability, profit growth, debt levels, all the fundamental characteristics you learn during your first week in business school,” he said.

Kaplan said that the share price is trading in a range but that he expects a significant drop.

“It’s like a truck turning around. It’s a slow move. The truck has to get to the exit ramp, go over the overpass. But a reversal is coming.”

Kaplan said he would avoid any long exposure to the ETF at this time whether directly or through the notes.

The terms of the notes did not meet his outlook.

“The 10% buffer is not enough for the protection. The chances of a price drop by a large percentage are too high,” he said.

The notes priced on Oct. 16, setting the initial price at $90.19. The $81.17 buffer level was seen as recently as July.

A bigger buffer would have been more justified than the high leverage multiple, he said.

“There’s very little chance to gain from this note, so the leverage... the cap are not going to be relevant,” he said.

For Kaplan, the chances of losing money during the 18-month period are just too high.

“Insiders have been aggressive sellers of the shares. It’s usually not a good sign.

“The energy bubble is not nearly as advertised as the AI bubble. It’s kind of a quiet bubble. But it’s a bubble.

“The timing for this trade is not compelling. I would avoid it,” he said.

Scotia Capital (USA) Inc. is the underwriter.

Goldman Sachs & Co. LLC is the dealer.

The notes will settle on Monday.

The Cusip number is 06417YVX4.

The fee is 1.13%.

© 2015 Prospect News.
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