Morgan Stanley’s buffered notes linked to S&P, Dow may disappoint on upside, contrarian says

By Emma Trincal

New York, Nov. 8 – Morgan Stanley Finance LLC’s 0% buffered participation securities due Nov. 14, 2025 linked to the worse performing of the S&P 500 index and the Dow Jones industrial average present more risk on the upside than on the downside, said contrarian portfolio manager Steven Jon Kaplan, founder of TrueContrarian Investments.

“You might as well put your money in your mattress. You’re not going to lose money with this big buffer, but you’re unlikely to come out ahead either,” he said.

The payout at maturity offers no leverage. If both indexes finish positive, the payout at maturity will be par plus the gain of the laggard index up to a maximum payout of par plus 78%, according to a 424B2 filing with the Securities and Exchange Commission.

If either index falls but not by more than 40%, the payout will be par.

Otherwise, investors will lose 1% for each 1% loss of the lesser-performing index beyond the buffer.

Long term, no problem

“I like the term,” he said.

“Six years is fine because it gives you time to recover after a bear market. The problem is that you start at a very high point. U.S. stocks are not trading at a bargain. The U.S. markets are overvalued. If you look at the Shiller CAPE ratio, they’re currently more than double their historical average.”

The S&P 500 Shiller CAPE ratio, also known as the Cyclically Adjusted Price-Earnings ratio, is defined as the S&P 500's current price divided by the 10-year moving average of inflation-adjusted earnings. The metric is often used to assess long-term stock market valuations.

“The long duration of the note is not an issue. The main concern is valuation. As stock prices are going to fall, I don’t think you’ll have enough time to recover, and if you do, your gains will be very small,” he said.

High correlation

The worst-of payout was also not a concern for this value-focused investor given the high correlation between the two U.S. large-cap equity benchmarks.

“They’re both overvalued, but at least they’re moving in the same direction. It’s not like having gold miners and S&P,” he said.

“The risk in a worst of is that one would perform well while the other would do poorly. But given the high entry points, they’ll probably both do really poorly, so the worst of should be the least of your worries.

“Your biggest problem here is not the worst of. Your biggest problem is valuation.”

The capped upside is only too low for bullish investors expecting to earn more. For Kaplan, a cap of 78%, or a little bit less than 13% a year on a compounded basis, was not objectionable.

“Thirteen percent is OK, but that’s if you can hit the cap. Stock prices are so high right now, this cap won’t matter.”

What’s wrong?

With a good tenor and cap and a high correlation between the underliers, what made this portfolio manager skeptical about the potential offered by the notes?

“For one thing, you don’t have any leverage,” he said.

“You also don’t get the dividends for six years. That’s a lot of compounding power to give up. You are guaranteed to underperform the total return of the index.”

He added that giving up dividends may be justified to price a 40% buffer, which will provide an efficient downside protection. But he doubted that investors may get any attractive return on the upside.

The main culprit, he explained, was not the lack of dividends but the timing of a trade as a bear market is underway.

From high to high

“People misunderstand bear cycles. They look at how long they last. They don’t take into account how long it takes to go back to the pre-bear market level,” he said.

He gave the example of the more than 15-year recovery period that followed the burst of the dot-com bubble.

“The 5,132.52 Nasdaq intraday peak of March 10, 2000 was finally surpassed on June 18, 2015 when the Nasdaq reached an intraday high of 5,143.32,” he said.

“That’s a very long time to go back. But that’s because you started at a very high point. There was a lot of speculation back in 2000, and market valuations were excessively high.”

Another example was the last bear market.

The S&P 500 peaked in October 2007 before plunging into a bear market, which would end in March 2009. But only in March 2013 did the index surpass its pre-crash high of October 2007.

If the recovery was shorter for the last bear market, it’s because the S&P 500 at that time was not as overvalued as in 2000, he said.

Today’s market valuations should give investors pause.

“If you use the Shiller CAPE ratio, the S&P has never been as high as today except in 1929 and in 2000,” he said.

The length of the recovery time following a bear market is therefore very closely related to pre-crash valuations. As an example, it was not before 1953 that the nominal value of the S&P 500 reached its 1929 level, he said.

“Certainly, when you buy stocks as high as they are now, you’re running the risk of a big drop.”

Another misconception about bear markets, he added, is how deep such drop may be.

Nasty bear market

“You just don’t go from overpriced to fair value. Once you get to more normal levels and hit fair value, it’s going to drop more because people panic and sell massively,” he said.

Using the current and median Shiller PE ratios as well as the S&P 500 closing price of 3,093 on Friday, he estimated that the fair value for the benchmark should be at around 1,600. This would represent a 48.3% decline.

The median Shiller PE ratio is 15.76, and the current ratio is at 30.45.

“Roughly speaking, you’d need a 50% drop to get to fair value,” he said.

From that 1,600 level, he applied a 40% discount based on historical data, with discounts to fair value in the past ranging from 30% to 50%.

A 40% index decline from Kaplan’s estimated fair value of 1,600 would put the index at 960. From today’s price to 960 is a 69% decline.

“We’ve been here before,” he said. Between its high in March 2000 and its low in October 2002, the Nasdaq lost nearly 79%, he added.

Risk on upside

Despite his bearish outlook, Kaplan did not think the notes posed a great risk on the downside. In his view, the 40% buffer offered a solid protection. His main point was that it takes a long time for bear markets to go back to their previous highs.

“If we see a big drop as I anticipate, there is still time and the size of the buffer is likely to work in your favor. Therefore, I think it’s unlikely that we should be down 40% six years from now,” he said.

“But I use the mattress analogy because I think it’s also unlikely that the S&P will be above 3,093 in six years.

“Maybe that could happen if we had an annual rate of inflation of 10%. But then inflation would not be good for stocks.

“The chances of coming out ahead are slim. This is why I think you might as well keep your cash under the mattress.”

Roll those T-Bills

As an alternative to both the “mattress” and the notes, Kaplan would buy four-week Treasury bills and roll them over throughout the same period of time. The bills, which yield 1.56%, would generate about 10% in return after six years.

“And that’s assuming rates wouldn’t go higher, which is unlikely,” he said.

“It’s not a high return, but it’s safe, liquid and tax-advantageous.

“This note has a great buffer, but you may not make any money at all. If I did a trade like this, I’d prefer to start at a very low point. And right now, U.S. markets are at all-time highs.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes were expected to price Friday and will settle on Thursday.

The Cusip number is 61769HF26.

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