JPMorgan’s dual directional notes tied to S&P 500 could strongly outperform, but timing counts

By Emma Trincal

New York, Aug. 20 – JPMorgan Chase & Co.’s 0% capped dual directional contingent buffered equity notes due Aug. 31, 2017 linked to the S&P 500 index could deliver impressive excess returns in a down market, but the timing and intensity of the downturn will make all the difference between exceptional returns and steep losses, financial advisers said.

If the final index level is greater than the initial index level, the payout at maturity will be par plus the index return, subject to a maximum return that is expected to be at least 17% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the final index level is equal to the initial level or less than the initial level by up to 20%, the payout will be par plus the absolute value of the index return.

If the final index level is less than the initial level by more than 20%, investors will lose 1% for every 1% that the index’s final level is less than its initial level.

Not for bulls

Steve Doucette, financial adviser at Proctor Financial, said there is no reason for bulls to invest in the notes. But for someone with a negative outlook, the reward could be significant.

“You have to be more pessimistic than optimistic because you’re long the index and your return is capped. But with the 20% absolute return, there is the possibility for a significant outperformance,” he said.

If at maturity the S&P 500 were to drop 20% from its initial level, investors would realize a 20% gain, according to the terms of the deal.

“That’s a 40% difference with the market. The potential for outperformance is huge,” he said.

On the other hand, if the index were to finish positive, investors would see their return capped at 17%, or about 8.5% per year, without a chance to beat the market, he noted.

“If you’re optimistic about the index, of course you wouldn’t be buying this because of the cap. Granted ... nothing indicates that stock prices are going to soar in the next two years. With the secular bull market we’ve been in, it’s hard to imagine any return in excess of 8.5%.

“So theoretically, someone who’s moderately bullish could use this. But then there’s absolutely no point in buying the notes. You could just buy the index.

“You have to be somewhat pessimistic. If you’re looking at a market decline of up to 20%, you’re going to be paid handsomely.”

Voodoo

The two-year term is a factor of uncertainty as it may put investors at a disadvantage.

“The hard part with these absolute returns is to tell where the market is going to be at maturity,” Doucette said.

“You could have a pullback followed by a market rebound.”

He said it is unclear whether such scenario is more likely to play out over a two-, three- or five-year timeframe.

“Structured notes give you a defined outcome. The only uncertainty is where the market is going to be,” he said.

“Clients say these notes are voodoo. No, they’re not. The only real voodoo is timing.

“What you want with this note is to hit the 20% window on the downside.

“The market could pull back 22% and come back 4%.You would get a huge outperformance.”

But if the final return “misses” that 20% range on the downside, investors would be incurring significant losses.

To limit such risk, Doucette said he would probably try to renegotiate the terms with the issuer.

“I probably would ask them to lower the upside cap in order to widen the absolute return range on the downside. I think it would make sense,” he said.

Early bear

For Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments LLC, the short duration is clearly the flaw in the structure.

“The big problem with that is the S&P is close to its top. The chance of the index dropping more than 20% in two years is very high,” Kaplan said.

“Actually, the biggest chance of a correction will be at the end of the next two years, in 2017.”

Kaplan said that the S&P 500 hit an intraday high for the year at 2,134.72 on May 20 and that there has not been any new high since then.

“It’s not that the market has been down a lot since then, but we haven’t had new highs,” he said.

“Bear markets typically start slowly and then you have a significant drop. On average, bear markets last between two and two and a half years.

“We’re now at a point where we’ve had three months without a high. We’re probably at the early stages of a bear market. If that’s the case, a 20% drop in two years is very likely, which leads me to think that 20% is not nearly enough protection.”

Between the peak of the market in October 2007 and the bottom in March 2009, the S&P dropped nearly 60%, he noted.

“A five-year note would have been much better. Now the market is about to turn and you may be at the bottom when the note is coming due,” he said.

J.P. Morgan Securities LLC is the agent.

The notes are expected to price Aug. 27 and settle Sept. 1.

The Cusip number is 48125UP30.

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