Rising prices for options to protect against losses in the S&P 500 over the next year show doubts about the market's ability to sustain its hefty gains
By Jeff Kearns and Lynn Thomasson
(Bloomberg) — Forecasts for the fastest U.S. earnings growth in 15 years are failing to convince options traders that the Standard & Poor's 500 Index will extend its biggest rally since the 1930s.
S&P 500 options to protect against declines in stocks over the next year cost 22 percent more than one-month contracts, the highest since 1999, data compiled by London-based Barclays Plc and Bloomberg show. The gap shows concern that analyst estimates for record earnings by 2011 may prove exaggerated, endangering an advance that pushed the S&P 500 up 63 percent since March.
"It's telling you that there's severe anxiety about the future," said Paul Britton, chief executive officer of New York-based Capstone Holdings Group LLC, which oversees about $1 billion. "People want to protect next year, and there's a sense of urgency."
The last time the average gap between one-year insurance and 30-day contracts was higher was five months before the S&P 500 began a 49 percent plunge in March 2000 during the collapse of the Internet bubble. More than $5 trillion has been restored to U.S. shares this year after the government lent, spent or guaranteed $11.6 trillion to end the worst recession in seven decades.
There's an 80 percent chance stocks will plunge next year, John P. Hussman, whose $5.5 billion Hussman Strategic Growth Fund (HSGFX) beat 99 percent of peers in 2008, wrote in a posting on his Web site Nov. 30. Albert Edwards, Societe Generale SA's London- based global strategist, wrote in a Dec. 1 research note that U.S. equities will fall below their March lows as the global economy weakens.
One-year implied volatility, which measures the price of options, on the S&P 500 has jumped to 24.16, or 4.42 points higher than the level for one-month contracts, Barclays data using 10-day moving averages show.
Option prices are rising on speculation the Federal Reserve will lift interest rates in 2010 or risk stoking inflation. Fed funds futures show chances the central bank will boost interest rates by its June meeting rose to 54 percent on Dec. 4 from 31 percent a week ago after U.S. unemployment unexpectedly fell in November, according to data compiled by Bloomberg.
"The market is enjoying what some are calling 'the calm before the storm,'" said Justin Golden, a strategist at New York-based Macro Risk Advisors, which advises institutions on derivatives trades. "Future expectations of volatility far outweigh the present. This spread paints a picture of the extreme uncertainty premium that exists in future equity prices."
Fed Chairman Ben S. Bernanke said at a Senate Banking Committee hearing on Dec. 3 that he doesn't rule out using monetary policy to pop asset-price bubbles.
"Supervision, regulation of the financial system is the strongest, most effective" way to deal with bubbles, Bernanke said in response to a question at the hearing considering his nomination to a second four-year term. "I do not rule out using monetary policy if necessary, if that situation does become worrisome and threatening."
U.S. stocks advanced last week after U.S. employers cut the fewest jobs in November since the recession began. The S&P 500 added 1.3 percent to 1,105.98. The dollar Index, a gauge of the currency against six major trading partners, increased 1.2 percent last week after sliding 16 percent since March 5.
The S&P 500 added 0.2 percent to 1,108.48 at 1:06 p.m. New York time today after managed-care providers rallied on a Goldman Sachs Group Inc. upgrade. Bernanke said in a speech to the Washington Economic Club today that inflation expectations remain "stable."
Investors are buying stocks on speculation the worst is over for the U.S. economy and rebounding consumer spending will help companies meet growth estimates. Gross domestic product increased by 2.8 percent in the third quarter after contracting for a year and is forecast to grow an average of 2.8 percent a quarter through March 2011, data compiled by Bloomberg show.
The S&P 500 has erased almost half of its loss after sinking 57 percent to a 12-year low in March from its record of 1,565.15 in October 2007. Five Wall Street strategists surveyed by Bloomberg project an additional 9.6 percent climb to 1,212 by the end of 2010, according to data compiled by Bloomberg.
Analyst predictions for S&P 500 earnings growth of more than 20 percent in each of the next two years, the fastest since 1994, are attracting money to equities. Combined profits for companies in the index will rise to $78.61 a share in 2010 and $95.32 in 2011, compared with $62.82 in 2009, according to the mean forecast in a Bloomberg survey.
"Mutual funds, hedge funds, pensions and endowments were scared stiff, but now they've regained their appetite for risk," said Jean-Marie Eveillard, senior adviser to the $8.6 billion First Eagle Global Fund in New York and a finalist for Chicago-based Morningstar Inc.'s fund manager of the decade award for non-U.S. stocks. "It's a warning sign because everyone who wants to be invested already is."
Earnings growth among S&P 500 companies may be hindered in 2010 by appreciation in the dollar, options trading shows. Larger U.S. corporations generate about 33 percent of their sales abroad, compared with 20 percent for the smallest, according to data compiled by Charlotte, North Carolina-based Bank of America Corp. A declining dollar makes overseas sales more valuable when translated back into the U.S. currency.
Traders in the $3.2 trillion-a-day foreign exchange market are paying the highest prices in more than a year to protect against a sudden rebound in the dollar after the worst year since 2003, data compiled by Bloomberg show.
While the Dollar Index fell to a 16-month low last month, implied volatility on three-month call options that grant the right to buy the dollar versus the euro exceeded options to sell by 1.61 percentage points last week.
In the stock market, "people are getting more skittish and afraid and have the sense that there could be a correction coming," said Wasif Latif, vice president of equity investments at USAA Investment Management Co., which oversees $74 billion in San Antonio. "You're seeing that now in the forward implied volatility numbers and the spread between the shorter-dated and longer-dated options in the S&P 500."
The gap in equity options prices comes as the Chicago Board Options Exchange Volatility Index heads for the steepest yearly drop in its two-decade history. The VIX, as the equity derivatives benchmark is known, has declined 74 percent to 21.25 from its record high of 80.86 in November 2008, two months after Lehman Brothers Holdings Inc. filed for bankruptcy and world credit markets froze.
Lower readings in the measure of the cost of one- and two- month S&P 500 contracts indicate more confidence among investors because the VIX rises more than 80 percent of the time when stocks fall, Bloomberg data show.
The higher price of one-year S&P 500 options means the VIX, a gauge of expected price swings over the next 30 days, is giving an incomplete view of investor concern, according to Carl Mason, the New York-based head of U.S. equity-derivatives strategy at BNP Paribas SA, France's largest bank. VIX futures also show bets that risk will increase, with March contracts closing at 27.80 last week.
"We've seen a lot of interest in hedging strategies, and there's an awful lot of uncertainty through next year," Mason said. "People have got a queasy feeling."
Money managers are also buying options to lock in gains this year after the S&P 500 lost 38 percent in 2008, its steepest decline since 1937. The index's 22 percent increase since December is its biggest annual advance since 2003.
Investors who bought shares of companies with rising earnings estimates have been rewarded. The average analyst forecast for next year's profit at American Express (AXP), the biggest credit-card issuer by purchases, has more than doubled since April to $2.28 a share. The New York-based firm has surged 112 percent this year for the steepest rally in the Dow Jones Industrial Average.
Estimates for 2010 profit at Caterpillar (CAT), the world's largest maker of construction equipment, have risen 81 percent since July. The Peoria, Illinois-based company has rallied 144 percent since the March low.
Increasing debt delinquencies at lenders may end the stock market rally, according to Hussman. The Federal Deposit Insurance Corp. said 4.94 percent of loans and leases were overdue at the end of the third quarter, the highest proportion in 26 years that insured institutions have reported data.
'Second Market Plunge'
"There is still close to an 80 percent probability that a second market plunge and economic downturn will unfold during the coming year," Hussman wrote.
Worldwide losses at financial institutions from the collapse of the subprime-mortgage market have exceeded $1.7 trillion, helping cause the worst global recession since the 1930s.
The recession will worsen as businesses and consumers reduce debt and deflation remains a "key threat" for the world in the next one to two years, said Societe Generale's Edwards in his note to clients. The S&P 500 fell to a 12-year low of 676.53 on March 9, according to data compiled by Bloomberg.
"I can understand why, longer term, people might have more concerns," said David Kelly, who helps oversee $480 billion as chief market strategist at JPMorgan Funds in New York. "You're just not going to feel comfortable again. It's like how people act after an earthquake: Any rumble in the ground and they run for the hills."
To contact the reporters on this story: Jeff Kearns in New York at firstname.lastname@example.org; Lynn Thomasson in New York at email@example.com.