BofA’s $23.52 million ARNs on Energy SPDR ETF offer no margin of safety, contrarian says

By Emma Trincal

New York, Dec. 2 – BofA Finance LLC’s $23.52 million of 0% Accelerated Return Notes due Jan. 26, 2024 linked to the Energy Select Sector SPDR fund give investors exposure to one of the most popular sectors in the U.S. stock market. But the overvaluation of the underlying shares and the lack of any downside protection in the structure make the bet highly speculative and risky, according to Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The payout at maturity will be par of $10 plus triple any ETF gain, subject to a maximum payout of par plus 41.6%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be exposed to any ETF decline.

Too rich

“The price of this fund is very high,” said Kaplan.

“Insiders have been aggressively selling it the whole month of November.”

Adjusted for dividends, the ETF hit an all-time high on Nov. 14 at $94.71.

The Energy Select Sector SPDR Fund, which is listed on the NYSE Arca under the ticker “XLE,” is up more than 62% year to date.

“Energy is the biggest winner among all sectors, so people are piling into it,” he said.

“People are selling some of their losers and buying expensive stocks like the shares of energy companies.

“I’m short energy. The sector is way overvalued.”

Predicting crises

The excessive buying suggested impending danger for this contrarian investor.

Financial crises can be predicted based on past asset price growth and past overheating in credit markets, he said, citing research from Harvard Business School published in April.

“When a sector outperforms the market by at least 1% for two years, there is a more than 50% chance that it will drop more than 40% over the next two years,” he said.

The probabilities and percentages of price declines increase significantly more as the sector outperformance grows.

The ultimate indicator

With commodities-related stocks, investors should be cautious about applying the traditional tools of fundamental analysis, he warned.

“Indicators like price-per-earnings do not help really when you’re dealing with energy shares,” he said.

The ETF shows an 8.56 P/E.

“It’s accurate but misleading,” he said.

“You can’t rely on P/Es when it comes to energy. The P/E of energy companies is going to change continuously. It depends on the price of energy going up or down and we know how much and how often energy prices go up or down. When they drop, energy producers have to shut down wells. They run only the best ones, those yielding the highest margins, which inflates profits artificially,” he said.

The cycle reverses itself when more wells can be put to work during the next energy cycle.

The only reliable indicator of value for Kaplan is insiders’ activity.

“Are they buying? Are they selling? Right now, they are aggressively selling. In 2020, they were buying at record highs. Now they’re selling at record highs,” he said.

Beware the headlines

The disconnect between insiders’ activity and mainstream investors should raise a red flag, said Kaplan.

“Stocks are down, bonds are down, real estate is down. It’s understandable that in a bear market, people would want to buy the winners,” he said.

But he did not recommend the strategy.

“It only feeds the bubble we’re in. Unfortunately, the media make things even worse by creating and maintaining a false narrative.

“Ukraine for instance makes a good story. Headlines predicted an oil shortage due to the war. Meanwhile, the price of oil right now is lower than before the Russian invasion. The media hyped it up,” he said.

A similar “false narrative” occurred when the media last year predicted a shortage of semiconductors.

“Instead, there is an oversupply of chips. People trade on hype,” he said.

Lower demand rather than squeezed supply help explain the current lower oil prices, he explained.

Hangover

“The world economy is slowing. People are consuming far less energy. Current oil prices do not justify the rally in oil stocks,” he said.

Most assets are in a bubble right now, he said. For many of those assets, the bubble has already burst.

Mega-cap growth stocks for instance began to decline at the end of last year, he noted. The rest of the market peaked in early January.

“There is no particular catalyst other than the consequence of excessive speculation and excessive borrowing. It’s just the hangover after a wild party. If you keep on drinking, you’ll eventually have a hangover,” he said.

The bear markets starting in 1929, 1973 and 2000 also lacked any particular trigger other than excessive bullishness, he said.

Bearish call

To be sure, energy has not yet “crashed,” but prices have slowly begun to decrease.

“By the middle of 2023 it will probably be down by half,” he said.

His prediction was based on past historical cycles. As the stock market collapsed in March 2000, energy shares only fell in the spring of the following year.

“Energy always lags. Price drops in this sector tend to take longer,” he said.

Even with the best structure, the notes offered no value for investors due to the overvaluation of the underlying.

Unfortunately, the structure itself was not optimal, according to Kaplan.

“You’re getting in a very risky sector. There is no margin of safety in the price and no protection in the structure. No buffer. No barrier. We’re at all-time highs. Now why would you want to take the chance of losing half of your investment?” he said.

Try the unloved

The popularity of energy among investors and structured notes buyers was concerning, he said.

“I’m always surprised about issuers coming up with notes at the worst possible time with the most trendy, inflated assets ready to burst. Why buying something in the least favorable conditions? The odds are not in your favor when you don’t pay attention to value and it’s even worse in a bear market,” he said.

Not earning dividends was another issue. Although it is the case for every structured note, it represented a greater handicap with energy stocks due to the rich dividend yields traditionally paid by oil and gas producers to their shareholders.

Kaplan said he would reverse his short positions if he saw heavy buying activity among insiders of the top holdings of the fund, such as Exxon Mobil Corp., Chevron Corp., Schlumberger NV and EOG Resources Inc.

“We’re not there yet. All the insiders of these companies have been selling in the past month. No exception,” he said.

Underlying sector

The Energy Select Sector SPDR Fund along with the SPDR S&P Oil & Gas Exploration & Production ETF are the most popular energy ETFs. Combined (and used individually) they make for $400 million in total sales for this year through Nov. 23, according to data compiled by Prospect News.

Energy is the second most popular underlying sector after technology.

BofA Securities, Inc. is the underwriter.

The notes are guaranteed by Bank of America Corp.

The notes settled on Wednesday.

The Cusip number is 06054E135.

The fee is 1.75%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.