Energy exposure weakens Morgan Stanley’s contingent income notes on two ETFs, contrarian says

By Emma Trincal

New York, July 23 – Morgan Stanley Finance LLC’s contingent income securities due Aug. 3, 2023 tied to the worst performing of the Energy Select Sector SPDR exchange traded-fund and the VanEck Vectors Gold Miners ETF present key risk elements due to the valuations of energy companies as well as the broad market, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

Quarterly, the notes will pay a contingent coupon at the rate of 9% to 11% per year if each ETF closes at or above its coupon threshold level, 70% of its initial level, on the related determination date, according to a 424B2 filing with the Securities and Exchange Commission.

The exact rate will be determined at pricing.

The payout at maturity will be par plus the coupon unless any ETF finishes below its 70% downside threshold, in which case investors will be fully exposed to the decline of the worst-performing ETF from its initial level.

Safer asset

Kaplan said that the less popular of the two funds was the more attractive one.

“GDX is a good one. The fund experienced big outflows last week. I bought GDXJ this week,” he said.

The ticker symbols “GDX” and “GDXJ” refer to the VanEck Vectors Gold Miners ETF and the VanEck Vectors Junior Gold Miners ETF, respectively. The junior gold miners fund consists of smaller-cap gold stocks, which are also more volatile.

“GDX is not overvalued,” he said.

“In fact, it’s a lot lower than its 52-week high of a year ago.”

Kaplan said the gold miners ETF was likely to be the best-performing fund of the two. His view was in part based on a bearish outlook on global equity markets in general.

“Gold and gold miners tend to do better during certain periods of bear markets. We’re probably at that phase right now. Gold did extremely well between early 2000 and December 2003.

“It could be a very good time to invest in GDX today,” he said.

Better entry point

In addition, gold miners are now attractively priced, he said.

“We’ve seen a lot of selling recently. About 0.8% of GDX’s total value was withdrawn. It’s a really big outflow.”

He explained why.

“People want to get rid of underperforming assets. They want to own the ones that are going up. Investors are chasing returns. They’d rather buy something expensive but popular. It’s the herd mentality,” he said.

The VanEck Vectors Gold Miners ETF is down more than 11% year to date.

Record global inflows

Kaplan justified his bearish view on equity markets from a contrarian standpoint: as insiders are selling, investors around the world continue to buy richly priced assets, pushing valuations to record highs.

“People everywhere, not just in the U.S. are pouring into equity, which is a red flag,” he said.

About $580 billion worldwide have been invested in equity funds in the first half of the year, making those vehicles on track for a record inflow, he said, citing a recent article in the Financial Times, which mentioned data from EPFR and a recent study from Bank of America strategists.

“What they’re saying is that if it goes on like this, there will be more equity inflows in the first half of 2021 than in the last 20 years combined,” he said.

“The stock market is totally overpriced, and insiders are selling at record levels. But people don’t care.

“They see a market that keeps on rising and they’re chasing after gains. Money continues to flow into overvalued equity funds.

“People really believe it can go on forever. But it won’t,” he said. “When you have such a bubble, such eagerness to speculate in almost every single asset class, a massive reversal is almost unavoidable.”

Downside risk

These bearish signals bode well for the gold miners, he said. Unfortunately, the note’s exposure is to the worst, not the best performing ETF. The Energy Select Sector SPDR, which trades under the ticker “XLE,” would be especially exposed to a pullback, he said.

“I would be much more worried about XLE. It has gone up so much. It’s the riskiest one,” he said.

The fund, which closed at $48.52 on Friday, is more than 14% off its 52-week peak of June. But its price remains 80% higher than its 52-week low. This $26.98 low was posted on Oct. 29, 2020.

“You still have a pretty big downside,” he said.

If the stock goes back to its end of October level, investors will incur a 44% loss, he noted.

“We were there less than nine months ago. We could revisit that low point again. If we do, it’s an enormous drop. A 44% decline makes the 70% barrier irrelevant. You’re long the fund,” he said.

Correlation

Another problem with the note was the worst-of payout. Kaplan pointed to the negative correlation between the two ETFs. The coefficient of correlation between the underliers is minus 0.232.

“Energy and gold miners are two completely different sectors. Energy is a useful indicator of inflationary pressures and economic growth. GDX is the opposite. It outperforms during bear markets and recessions,” he said.

“They have nothing in common except to be both commodities funds.”

Weak or negative correlations increase dispersion risk for investors.

“Each time you have a worst-of you want to be as correlated as possible,” he said.

“XLE is probably going to drag your return down. Chances are you’ll have the exposure to this fund. That’s where the risk lies in this note.”

Tenor, bullet

Kaplan examined two other important aspects of the product: its length and the absence of any call feature.

“Every asset class is overpriced, not just the stock market. The real estate market is overpriced, corporate bonds are overpriced, Bitcoin is overpriced. Two years is long enough for the stock market to crash but not long enough to recover,” he said.

The bullet format of the note was another negative.

“You don’t even have a chance to be called. You’re stuck with what the performance is going to be in two years. Your risk exposure doesn’t go away.

“I think there is significant risk in this note. It would have been a very different story if it was only linked to GDX. Energy is a poor choice,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price on July 30 and settle on Aug. 3.

The Cusip number is 61773FDL4.

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