JPMorgan’s $1.42 million notes on EAFE ETF, Stoxx offer defensive features with barrier, tenor

By Emma Trincal

New York, Jan. 03 – JPMorgan Chase Financial Co. LLC’s recently priced $1.42 million of 0% uncapped contingent buffered return enhanced notes due Dec. 26, 2024 linked to the lesser performing of the Euro Stoxx 50 index and the iShares MSCI EAFE exchange-traded fund can be an attractive play to get long-term exposure to international equity, said Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments.

If each asset finishes above its initial level, the payout at maturity will be par plus 2.15 times the gain of the lesser-performing asset, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the lesser performing asset falls by up to 50%.

Otherwise, investors will lose 1% for each 1% decline of the worse performing asset from its initial level.

“Overall this deal has some definite positive features,” he said.

“No cap is very good. 50% on the downside is more generous than a lot of barriers that you see. You’d have to be down by more than half in five years in order to lose money. It’s not likely to happen.

Long-term benefits

The longer duration was an advantage as well. This portfolio manager expects the market to be “in a higher point in the cycle” five years from now.

He explained why.

“If we have a recession, it’s likely to happen in the next few years. We had negative divergence warnings lately signaling a market pullback. Five years gives you a couple of years to recover.”

While the bulls have been in control last year with the S&P 500 index gaining 11.5% just in the last three months and 29% for the year, Kaplan does not see this rally as sustainable, especially with U.S. stocks’ current valuations.

The “negative divergence” he referred to was the discrepancy observed between the performance of large caps as measured by the S&P 500 index or the Dow Jones industrial index and the small-cap universe reflected by the Russell 2000 index.

Russell indicator

“Every time in history smaller caps hit a high before the large companies, a major pullback or bear market was coming.”

The Russell 2000 reached its peak in 2018 but is still below that level, he said.

Even though it hit a new 52-week high in December it has not retested its prior high of August 2018, he said. Meanwhile the S&P has surged to another all-time high as recently as Thursday.

“Large caps keep on hitting new highs while the Russell has not and for some time now. We’ve seen similar patterns preceding bear markets in the past,” he said.

Lessons of history

He pointed to the last bear market of 2007-09.

“The Russell 2000 formed a double-top on June 11 and July 9 of 2007 while the Dow peaked later in October. There was a divergence, a lag. While it didn’t last very long the pattern was there. Small caps hit an all-time high ahead of large caps.”

During the early 1970s, small caps peaked in 1971 well ahead of the S&P 500, which rose to a high in January 1973, he said.

Finally, the 1929 crash saw a similar trend: small-capitalization stocks reached a high in 1928 ahead of the S&P 500 whose value topped on Labor Day of 1929. The sell-off began at that time before culminating in panic at the end of October.

Whether the time elapsed between the highs of the two markets –small- and large-caps – is long or short-lived does not change the predictive power of the divergence, according to Kaplan.

Deep barrier

If the long maturity of the notes played to the advantage of investors, the structure also offered good protection against the risk of market losses.

“This barrier is very effective in protecting your principal,” he said.

“It doesn’t mean you are going to make money necessarily. If the worst-of is down by less than 50% you won’t lose anything but you can argue that you’ve lost the opportunity to put your money in the bank and earn a small return,” he said.

“You’re also not earning the dividends.

However, investors in the notes fare better from a risk standpoint than equity investors.

“Certainly, it’s possible it could be down five years from now. But if the market is down 30%, getting your entire principal back is a much better result than collecting your dividends with a 30% loss.”

European concentration

The choice of the two underlyings was not optimal, but certainly preferable to any U.S. equity assets, he said, as he considered U.S. stocks to be overly expensive.

“They do overlap a little, which is a good thing,” he said about the two underlying assets.

The Euro Stoxx 50 index tracks countries from the eurozone. The iShares MSCI EAFE ETF, which replicates the index of the same name, offers exposure to developed markets excluding the U.S. and Canada. But 60% of the fund consists of European stocks, either out of the eurozone (U.K., Switzerland) or within it (France, Germany, Netherlands, etc.).

FX exposure

He noted one divergence, however, pointing to the currency denominations.

“The ETF is measured in other non-U.S. currencies while the index is in U.S. dollars. If the U.S. dollar ends up very strong it would hurt the performance of the ETF. The worst-of may end up being the ETF, as a result,” he said.

“So, they may not diverge so much in terms of their performance but you could see a divergence induced by the currency exposure. However over five years, that type of divergence may not be that significant.”

Average value

More pressing than exchange rate risk was the issue of valuation.

Kaplan said he seeks undervalued assets across all markets.

Europe is in the middle ground.

“In this current bull market, European stocks are not particularly high. They’re more average than high. But they’re not trading at a bargain either,” he said.

“I always prefer to have undervalued assets. It’s a way to limit your downside risk,” he said.

“That being said, the 50% barrier is a good way to control your risk along with the timeframe.

“Even if it dropped by that much, you’d still have time to recover and get your money back.

“The chances of losing are small, which is a very good thing.

“The fact that it has such a solid protection and no cap are very positive features, and one should encourage issuers to do more of that.”

J.P. Morgan Securities LLC is the agent.

JPMorgan Chase & Co. is the guarantor.

The notes (Cusip: 48132HKG6) settled on Dec. 26.

The fee is 4.08%.

© 2015 Prospect News.
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