Credit Suisse’s $19.07 million autocallable notes on ETFs seen as risky in overvalued market

By Emma Trincal

New York, Jan. 22 – Credit Suisse AG, London Branch’s $19.07 million of autocallable contingent income securities due Jan. 20, 2023 linked to the least performing of the Energy Select Sector SPDR exchange-traded fund, the Financial Select Sector SPDR ETF and the Industrial Select Sector SPDR ETF involve considerable downside risk in today’s market, according to Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The use of three underlying ETFs without high correlations to one another was not the most alarming factor, he said. He emphasized instead the high valuations of these ETFs, a problem found with almost all equities at the moment in the stock market.

The notes will pay a contingent quarterly coupon at an annualized rate of 10% if each underlying closes at or above its coupon barrier level, 65% of the initial level, on the observation date for that period, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus the coupon if each underlying closes at or above its initial share price on any quarterly call observation date.

If the notes are not called and each underlying finishes at or above its downside threshold level, the payout at maturity will be par plus the final coupon. Otherwise, investors will lose 1% for each 1% decline of the least-performing underlying from its initial level.

Overpriced funds

Kaplan said a 35% drawdown was not unreasonable.

“These funds can drop a lot more than 35%. They can drop 70%,” he said.

“The risk is really serious because you come in at a high point.”

The Industrial Select Sector ETF hit an all-time high on Jan. 12 at $90.69.

The fund has gained more than 85% since its low in March.

“XLI is the most overvalued of the three. I would guess it could very well be the worst-of.”

“XLI” is the ticker for the Industrial Select Sector SPDR ETF.

“The energy one is the less overvalued over a long period. But it’s still 84% higher than in March.”

Up across the board

The lack of attractively priced assets in the U.S. equity markets was not limited to the three Select Sector SPDR funds used as underliers in the note, he said.

“There’s a high degree of overconfidence in the market, and it raises a red flag. Everything is overbought.

“The market has been rallying for months,” he said. “Gains have been huge since the bottom last spring. People project that what they’ve been seeing since March will continue in the future.”

Investors are overly bullish, he explained, as they share a “herd mentality.”

“They listen to the same news, read the same posts and make the same assumptions.

“The same headlines encourage people to be bullish despite unsustainable valuations: more stimulus will boost the market; the Fed will keep rates low, so stocks will continue to skyrocket; vaccines will prompt a V-shape recovery...

“People think all of this is going to continue, that it’s normal.

“That’s how you get bear markets. It’s when nobody expects a bear market that suddenly it happens.”

Timing the entry

Kaplan said he was not intrinsically bearish. But he avoids buying anything when prices are high.

“In March, I was extremely bullish. I was buying a lot. I was very bullish in April and May too, and again in September and October. You had energy stocks at bargain prices, shipping stocks, regional bank stocks at attractive prices.

“You can’t have the same view all the time.

“You have to periodically be bullish or bearish,” he said.

The main problem with the note was not its structure but its timing.

“When you come in at such a high point and get a bear market, you can see significant price drops,” he said.

That’s precisely what he expects.

“The entry points on these three sector ETFs are way too high. You’re taking great risks at these levels,” Kaplan said.

Insiders selling

Another sign keeping Kaplan watchful about stock prices was the rising tide of insiders’ selling.

“Insiders have been selling their own stocks at a record rate compared to their buying activity. The sell-to-buy ratio this month so far is at its highest in decades,” he said, referring to the Washington Service, a company that provides insider trading data.

“While inexperienced investors are piling on buying anything as long as it goes up, insiders, which are much more sophisticated, have been selling more than ever relative to what they buy,” he said.

“This to me means the market can drop any time.”

Unpredictable reversion

For investors in autocallables however, the hope, which is often backed by high probabilities, is to see the notes called on the first observation date – just after three months for this product.

“I know that people think it’s a great way to get a high coupon. They hope that in three months all three ETFs will be up. That’s the reasoning.

“They don’t understand that bear markets happen very suddenly. As soon as you have a big drop, it will accelerate. It could be in two days or in two months. No one knows.

“When there is no fear in the market, when everybody is extremely complacent and overly confident, that’s when you should be worried,” he said.

Kaplan conceded that bear markets can be brief.

On average, bear markets last approximatively 15 months. The last one in February was exceptionally short, with a 33-day length.

“But you don’t know how much it can drop. You don’t know how much it will go back up and how long it will take for the market to go back to where it was.”

The short maturity of the product was not an advantage.

“Depending on when the next bear market starts, we could still be holding the notes in two years,” he said.

Correlations

Investors in any worst-of deal should assess how correlated the performances of the respective underlying assets are since they are not exposed to just one asset but to the relative performance of the underliers.

Correlations are measured with coefficients of correlation on a scale of minus 1 to plus 1.

Kaplan said the three underlying funds, which track quite different sectors, could go in different directions.

“If they’re not correlated, it’s a negative,” he said.

The lowest coefficient of correlation at 0.79 is between the Energy Select Sector SPDR and the Financial Select Sector SPDR ETF. The highest one is between the Industrial Select Sector SPDR ETF and the Financial Select Sector SPDR ETF at 0.92. In between is the 0.87 coefficient of correlation between the energy and the industrial funds.

“You can’t really say the correlations between those funds are very low. But they’re lower than what you want. You want GDX and GDXJ for instance...things that are more tightly bound to each other.

He was referring to the VanEck Vectors Gold Miners, an ETF listed on the NYSE Arca under the ticker “GDX,” and to its cousin fund – the VanEck Vectors Junior Gold Miners – listed under the “GDXJ” ticker.

Those two funds have a correlation close to 1.

More concerning than the correlations, the intensity of the bullish momentum should incite investors to be particularly cautious.

“There is a level of exuberance and speculation that signals an impending bubble burst.

“It’s early 2000 on steroids,” he said.

Credit Suisse Securities (USA) LLC is the agent with Morgan Stanley Smith Barney LLC as a distributor.

The notes priced on Jan. 15 and settled on Jan. 21.

The Cusip number is 22551F327.

The fee is 2%.

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