How and When to Deploy into Equities

How and When to Deploy into Equities

Good Afternoon Clients, Colleagues and Friends,

I hope this letter finds you and your loved ones safe, healthy, and sane in these challenging times.

As we all deal with the impact of this coronavirus, we see the markets react with extreme volatility.  Many of you have inquired about the best timing and method to take advantage of these volatile equity markets, as we see continued downside pressure on stocks from COVID-19.  

Therefore, we are following up with information we promised in the last Client Update dated 3/16, regarding the Structured Note.  We have received so much interest in the Structured Note that we are forwarding to all of you at once.

For the last few days, we have been working with our underwriting counterparts on structuring a hedged equity note, and simultaneously building models to help us understand when to deploy it.  Most of you are probably less than familiar with structured notes, or at a minimum could use a quick primer. So, here’s how they work:

Structured notes are similar to bonds in that they have an issuer and a set future maturity date.  However, instead of generating interest income, they can be built to track the performance of an underlying equity index, and at the same time provide both enhanced upside and substantial downside protection.  

How is this accomplished?  Instead of buying the underlying index outright, a combination of put and call options on the index are purchased that expire when the note matures.  

If the note matures and the underlying index fund posts positive returns, the options purchased at inception create enhanced upside, sometimes as high as 160% or more.  By contrast, if the note matures and it has lost money based on the performance of the underlying index fund, the options cover a certain percentage of the loss down to a set threshold, say 10-20%.  There is NO levered performance on the downside.

There are a number of factors that influence the pricing of the options, but two of the big ones are volatility and duration of the note.  The more volatility, the more upside leverage is available for the same price. And right now, we have more volatility than the market has ever seen, which is creating a unique opportunity to structure these notes.  

The goal of these notes is to put volatility to work for us, as we look to regain equity losses and then some.  Our tools are time and volatility.

The second factor that makes these notes attractive is that the equity markets have presently declined approximately -31% off their February highs, and appear poised to go lower, as news of COVID-19 worsens.  

In response and preparation, we are implementing a staged capital deployment plan for entering the equity market.  This deployment plan mirrors what we now believe to be a two track crisis… virus and economy.  The virus is running out front and the economic numbers will follow as Q1 data starts to roll in.

We therefore plan on “legging” into this trade in three primary stages:

  1. Once we hit approx. -40% (on a big down day) we will be down more than the lows during an average recession. That seems an opportune time to enter with 1/3 of our full position size, whatever that may be.  
  2. The COVID-19 global pandemic appears likely to cause worse economic damage than an average recession, which is why we will then look to enter with another 1/3 of the allocated capital when/if the market begins to approach the trough we saw during the Great Financial Crisis of 2008-2009 (-54%).
  3. The final deployment will be opportunistic once we see actual improvement and contraction of the spread of the virus.

We realize it is nearly impossible to gauge how deep this recession will plumb or how long it will last.  Likewise, predicting the market’s response given the potential impact of unknown government intervention is even more challenging.  This is why we believe it makes sense to lift our head above the fray and look long-term to chart the best path forward.    

For those of you that do not believe the market will be higher in 5 years…this note is not for you.  For those that believe the market will bounce back, but aren’t sure how long it will take or how big the bounce may be, then this may be worth considering.

Returning to the key features of the note, right now it looks to be shaping up as follows:

  • Underlying Index:  S&P 500
  • Maturity:  5-7 Years
  • Downside Protection:  10-20%
  • Upside Leverage:  Minimum 160% (we won’t have the exact % until the day we issue the note, due to fluctuations in options pricing)
  • Return Cap:  None
  • Tax Treatment:  Long-term capital gains at maturity

Considerations for Participation

  1. Current eligible equity holdings.  Given the asymmetric upside return opportunity of the note, we may want to consider lightening up on existing positions and/or tax loss harvesting, knowing we have a much higher likelihood of participating more fully in the bounce back through the structured note over time.
  2. Discretion. We will need your permission to implement at our discretion, within 48 hours, once we have decide how much to deploy for each tranche. We have to strike the notes on the same day, for all clients, and that means we have to move autonomously.
  3. Funding. If you don’t already have an account with us that corresponds to where your cash is currently held (trust, individual, joint, IRA, etc.), we will need to open that for you and transfer the cash you wish deployed into that account. This takes a minimum of 2 business days, so please keep this in mind.

Once we lock pricing on the note, we will forward a two page summary of the note’s principal terms and features, as well at the note’s formal prospectus.   

Of course if you have any questions, please don’t hesitate to reach out to Will, Eric or I, to discuss live.  Otherwise, it’s time to make some lemonade out of these lemons and put some capital to work.


Jon Porter
Three Bell Capital

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