GS Finance’s bearish notes on Nasdaq lever up gains when stock prices are falling

By Emma Trincal

New York, April 11 – GS Finance Corp.’s 0% bearish leveraged index-linked notes due May 17, 2024 linked to the Nasdaq-100 index differ from most bearish-oriented notes such as dual directional products or pure bear plays in that it levers the “upside” when stock prices go down, sources said.

If the index finishes at or below its initial level, the payout at maturity will be par plus 185% of the decline of the index, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes above its initial level, investors will lose 1% for every 1% of index gain.

Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments, said the notes offered interesting benefits in current market conditions.

“It’s a very good bet. The market is so high, you have a very strong chance of making money,” he said.

Using the Nasdaq was an opportune choice for the underlying, a better one than most other indexes, including the S&P 500 index, he added.

“The Nasdaq is at its highest point since August. There’s a lot of potential decline, which means upside for those who own the notes,” he said.

The Nasdaq is up 15% year to date.

Bearish clues

In addition to overvaluation of the underlying, Kaplan pointed to other bearish signals, which may make the note worthwhile.

“The VIX has been below 19 for many days, a clear sign that people are too unconcerned about the bear market,” he said.

“A significant amount of call buying is taking place, another sign of extreme complacency. People are just bullish at the wrong time.”

The tech-heavy Nasdaq-100 index was likely to decline even more than the Nasdaq Composite index due to its high concentration on momentum stocks, he said.

Kaplan is short the Nasdaq-100 index via its ETF – the Invesco QQQ Trust.

“QQQ is close to triple fair-value. It’s even richer than the S&P. People are constantly fueling the tech bubble buying the same stocks like Microsoft, Apple and Nvdia, whose prices trade at a huge premium over fair value,” he said.

The portfolio manager liked the timing of the note as well.

“In my projections, a VIX repeatedly dropping below 19 and the U.S. dollar resuming its uptrend are signs that we could have a drop of more than 40% for the Nasdaq-100 index this year,” he said.

Kaplan was not concerned about a bullish scenario, which would put noteholders at high risk since the structure offers no protection against such scenario.

A potential example would be sudden Fed’s rate cuts. Most analysts and traders expect such a turn of events to be bullish for the markets.

Dangerous pivots

“Bulls constantly make that assumption. They think that if the Fed suddenly decides to cut rates, stocks will soar,” he said.

“But it has no basis in historical facts.

“The Fed cut rates many times during previous bear markets. It didn’t help. In fact, things got worse.”

During previous bear markets, stocks tended to collapse the most when the Fed was still engaged in easing cycles, he explained.

He offered some examples.

The Fed was cutting rates during the 2007-08 bear market, yet the S&P 500 index lost half of its value between September 2008 and March 2009 in spite of the central bank’s aggressive rate cuts.

In January 2000, the Fed cut rates and pursued its easing policy for more than a year. In March, the dot.com bubble began to burst pushing the QQQ down 83.6% by October 2002.

As investors continue to worry about a recession, a Fed pivot may not be a positive event this time again.

“If the Fed reversed course, it would be a red flag. People would start to worry that something has gone really bad with the economy,” he said.

Seeing little cause for concern about the risk posed by a bull market, Kaplan said he really liked the note for its bearish setup.

“It’s a very timely and unusual note,” he said.

Sell high

While the aggressively bearish tilt of the note may not be for everyone, some may find ways to use it to their advantage, said Tom Balcom, founder of 1650 Wealth Management.

“This is for investors who are definitely not upbeat about the market and the economy,” he said.

The note can be used in many ways, the most obvious one being a pure hedge, he added.

For some clients, the product may serve as a source of income.

“It may be very helpful for retirees who need cash,” he said.

“When these investors’ need for liquidity coincides with a market pullback, choices are often limited,” he explained.

“They have to sell stocks at lower prices. No one should have to do that. You want to buy low and sell high.

“This note gives them an opportunity to free up some cash when the market is down without being forced to realize a loss.”

You can also take your profit from this short-term note and reinvest the proceeds in a market that’s lower.”

Barriers, puts

Investors can also use the note as a protection.

“But you need to have a strong bearish view. If you do, the note allows you to monetize your belief. Of course, it’s very risky since you don’t have any protection when the market goes up,” he said.

Balcom said he would not buy the notes, preferring more traditional defensive securities.

“We typically hedge the downside with a barrier or a buffer. With this note, hedging can cost you a lot. If you’re wrong and the Nasdaq shoots up, you could lose 100% of your investment.

“That’s not a topic of conversation you want to have with a client. Not when everyone else is making money in a bull market,” he said.

Another protection can be achieved by buying one or several puts. Several puts are the equivalent of leveraging gains in a declining market.

“Buying puts is a good idea even though you pay a premium for your protection. The note is cheaper but much riskier. With puts you only risk your premium. Here you have 100% exposure to losses,” he said.

Only short-sellers would take more risk than holders of this bearish note, he said, since the risk in selling the index fund short is truly unlimited.

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the underwriter.

The notes are expected to price on April 14 and to settle on April 19.

The Cusip number is 40057RFU7.

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