BofA’s Bear Stars due 2021 tied to S&P 500 index come at the right time, contrarian says

By Emma Trincal

New York, Aug. 14 – BofA Finance LLC’s 0% Bear Strategic Accelerated Redemption Securities due September 2021 linked to the S&P 500 index fit the view of bearish investors concerned about the market nearing its all-time high on the heels of a steep rebound led by a limited group of mega stocks chased by too many inexperienced investors, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The notes will be called automatically at par plus a premium on any quarterly valuation date after six months if the index closes at or below its initial level on the related observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The premium will be 7.25% to 7.75% on February 2021, 10.875% to 11.625% on May 2021 and 14.5% to 15.5% on September 2021.

The exact call premium percentages will be set at pricing.

If the notes are not called and the final level of the index closes at or below its initial level, the payout at maturity will be par plus the premium applicable to the final observation date.

If the index finishes positive, investors will lose 1% for every 1% increase of the index.

For investors bearish on the market, the notes offer a strategy comparable to shorting the index, said Kaplan.

Short the market

“The difference may be that with the notes, you won’t ever lose more than 100% of your principal while shorting gives you unlimited exposure to losses when a stock keeps going up,” he said.

Avoiding such extreme risk is one of the advantages of the notes.

Kaplan said the notes may be replicated by shorting the stock and buying an out of the money call.

The call is “out of the money” when the price of the underlying is below the strike of the call option.

If for instance the trade consists of selling short the index at a current price of 100 and buying a call at 200, the long option, once “in the money” (or above its 200 strike price), would in effect cap the losses at 100 since each point of price increase above 100 causing the short position to lose money would be offset by the exercise of the call option once the price moves above 200. This would reflect the maximum potential loss of 100% that may occur with the notes.

Buying this out-of-the-money call would also be “very cheap,” he noted.

This equity strategy can be efficient for short sellers looking to hedge their losses in case of a rise in prices.

But the note buyers do not need to get involved with those complicated options trades, he said.

“It offers the advantage of simplicity, he said.

Mildly bearish

Another difference with a pure short play is the bearish outlook itself. Buyers of the notes should only be modestly bearish since their payout is limited to the call premium.

“You won’t make as much money with the note if the market drops a lot. Say the S&P is down 30% in six months, you’ll receive a 7.5% premium instead of a 30% profit. It’s a different risk profile, but if you have a moderately bearish view, it’s a reasonable play,” he said.

Kaplan said he liked the one-year maturity.

“The timing is good. That part is excellent. The S&P is almost at its all-time high and we’re getting a lot of negative divergences supporting a bearish outlook,” he said.

He cited three of them: the U.S. dollar, the technology sector and volatility.

Flight to quality

“The U.S. dollar is rising. It’s a risk-off move and we’re moving from a 27-month low. Such a strong jump from a record low means that the dollar is going to become a safe haven, perhaps replacing Treasuries in that role,” he said.

The number of possible “safe havens” available to risk-averse investors has greatly diminished, he noted.

“Treasuries are not as good. They have become too expensive. Corporate bonds are too expensive. Real estate is too expensive. The stock market is too expensive.

“There’s got to be something that investors want to buy, and the U.S. dollar may be one of those few assets,” he said.

Price weighted

Another bearish signal was the divergence between the performance of the mega-cap technology stocks and the rest of the market.

“People think this rally is going to continue forever,” he said.

“But the valuations are extreme. And tech is overweighted in the indexes. That’s a dangerous thing.”

Apple Inc., Microsoft Corp., Amazon.com Inc., Facebook Inc. and Google’s parent company Alphabet Inc. make for 22.6% of the S&P 500 index.

“It’s distorting the market. Everybody is chasing the same five big tech stocks and they’re so huge,” he said.

Bubble alert

The big stocks are also too expensive.

Those technology names trade at valuations that are unsustainable compared to their revenues and earnings, he said.

“People forget the law of gravity.”

Apple Inc. has a price-to-earnings ratio of 36 and its revenue growth is 12%, he noted.

“That’s a huge gap. The stock is way overvalued,” he said.

“Sooner or later Apple will drop, and it will impact not just Big Tech but the overall market.”

The new craze

The emergence of a new class of investors with little to no experience using trading platforms such as Robinhood has only made things worse as they tend to get easily “excited” and emotional, he said.

Robinhood Markets Inc. operates a mobile app and website allowing investors to trade stocks, ETFs, options and cryptocurrency.

“Those Robinhood millennials can buy fractions of shares with no commissions, get their tips from social media but they have no trading experience whatsoever,” he said.

“The number of new accounts to trade the stock market is the highest today. It’s higher than in 2000.”

Many of recent extreme price moves can be attributed to the “herd behavior” of those novice investors, he added.

“This is why we have bubble-like valuations in the tech sector.”

The same phenomenon may in part also explain the disconnect between the stock market performance and the struggling economy, he said.

Pricing risk

Finally, a third divergence supporting the bearish theme embedded in the notes was the behavior of the CBOE VIX index, the barometer of the S&P 500 index volatility.

“The VIX is staying in a range below 20 making higher lows while the S&P is making new highs. We had a similar divergence back in February just before the sell-off,” he said.

The current level of the VIX at 22 is not excessively higher than its long-term average. But 22 is much higher than the VIX in January, which traded as low as 12 during an uptrend.

“The VIX right now is not trading at a level the market reaches at a peak when it’s close to its all-time high. It’s twice as high as its pre sell-off level,” he said.

“People selling options are selling insurance. They’re among the most sophisticated market participants. They’re asking double premium because they know the market is not doing well.”

At maturity

One of the negatives of the structure was the absence of downside protection. Bears buying the notes lose money at maturity if the market is up. The potential for losing 100% of principal is there.

Kaplan was not too concerned about this possibility.

“First, chances are you’re going to be called in six or nine months,” he said.

Even without a call, Kaplan does not anticipate the S&P 500 to close higher in September 2021.

“I expect the market to drop significantly and bottom by the end of this year. It’s unlikely that it would recover by the time the notes mature, assuming you don’t get called in between.”

He acknowledged that market recoveries can be steep and speedy.

Since its March low, the S&P 500 index jumped 55% in less than five months. But Kaplan said such scenario is unlikely to happen again.

“The market held up and rallied only because of tech stocks. Once the sector blows up, the drawdown will be worse, and the recovery will probably drag on.

“The tech sector collapse in my opinion is already happening.”

Overall, Kaplan said he really liked the notes.

“The timing is right. It’s coming just at the right time.

“The call premiums will cap your return. But the chances of earning the premium are fairly high.

“It’s nice to see something a little bit different,” he said.

The notes are guaranteed by Bank of America Corp.

BofA Securities, Inc. is the agent.

The notes will price in August and settle in September.

© 2015 Prospect News.
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