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Monday, October 8, 2007

Stock Market Stumble Presaged as S&P 500 Options Spread Widens

By Jeff Kearns and Michael TsangOct. 8 (Bloomberg) --

Skittishness over the U.S. stockmarket's record-setting rally is reaching a crescendo amongoptions traders who are preparing for a crash.Investors are paying the most ever to protect against adrop in the Standard & Poor's 500 Index, data compiled by MorganStanley show.
The gap between the price of so-called put optionson the benchmark for U.S. equity and the cost to wager on further gains has averaged about 8 percentage points sinceAugust. That's more than the previous high in July 2001, before the index dropped 34 percent and fell to the lowest this decade.
The widening spread is a warning for OppenheimerFunds Inc.and Harris Private Bank, which oversee more than $300 billionand say the bearish bets indicate stocks may fall. The S&P 500rebounded 11 percent since Aug. 15 on speculation the worst isover for banks and homebuilders hurt by the collapse of subprimemortgages. Shares in developed markets outside the U.S. havedone even better, climbing 15 percent from their trough.

``Battle-scarred investors are buying some insurance thistime around, having the benefit of hindsight,'' said Jack Ablin,who oversees about $50 billion as chief investment officer atHarris Private Bank in Chicago. Ablin said he bought put optionsfor clients during the rally.The seven-week rebound in stocks allowed investors in S&P500 shares to recoup all the $1 trillion they lost during thebiggest plunge in four years. Global indexes fell as defaults onloans to people with poor credit and the worst U.S. housingslump in 16 years caused corporate borrowing costs to increase.The S&P 500, which dropped 9.4 percent between July andAugust, rose 2 percent last week to a record 1,557.59, eclipsingthe previous high of 1,553.08 on July 19. The Morgan StanleyCapital International EAFE Index of non-U.S. developed marketsgained 1.6 percent to 2,336.47, also ending the week at an all-time high.

Price Swings
The advance hasn't dispelled concern among traders in U.S.options. They are pricing in the highest risk of an equity-market decline since the technology-stock bubble burst at thestart of the decade, according to Carl Mason, head of U.S.equity-derivatives strategy at Morgan Stanley in New York.Mason says implied volatility, a measure that calculatesexpected price swings of an underlying asset and is used as abarometer for options prices, shows many investors are bettingthat stocks may fall.Since Aug. 15, the implied volatility of put options thatlock in gains should the S&P 500 drop at least 10 percent in sixmonths has averaged 24.08 percent, according to data from MorganStanley, the second-largest U.S. securities firm by market valueafter New York-based Goldman Sachs Group Inc.

Volatility Skew
The implied volatility on puts is 8.1 percentage pointshigher than for call options, enabling investors to profit ifthe index rises at least 10 percent in the same period. The so-called implied volatility skew climbed as high as 8.53 pointssince mid-August. That's steeper than 99 percent of all readings since the start of the decade, Morgan Stanley said. The median difference is 5.9 percentage points. The gap shows there's ``an awful lot of nervousness,'' saidMason.

``A lot of investors don't want to get caught out.''The last time the skew steepened as much was in July 2001,when it touched 8.24 percentage points, according to MorganStanley's data. In the following 15 months, the S&P 500 tumbledas the U.S. economy suffered its first recession in a decade.This time around, economic growth is also slowing,increasing the likelihood stocks will fall, according toOppenheimerFunds' Kurt Wolfgruber.

Slowing Economy
The U.S. economy expanded at an annual rate of 2.4 percentin the third quarter compared with 3.8 percent in the previousthree months, a Bloomberg survey of economists showed.
They expect growth this quarter to slow to 2.2 percent.Analysts have pared their earnings forecasts for S&P 500companies. They estimated profit growth of 0.7 percent in thethird quarter as of Oct. 4, down from 4.6 percent in mid-August.If the projections are correct, it would end a streak of 20 straight quarters of at least 10 percent growth.
Citigroup Inc., the biggest U.S. bank, last week said third-quarter profit fell 60 percent, while Merrill Lynch & Co.,the world's largest brokerage, reported its first quarterly lossin six years. Both New York-based companies cited losses on asset-backed securities and loans for leveraged buyouts.

``There's a good case to be made that the market is a bitahead of itself,'' said Wolfgruber, who oversees $265 billion as OppenheimerFunds' chief investment officer in New York. ``Things are less sanguine than they were three months ago.''Morgan Keegan & Co.'s John Wilson said interest-rate reductions by the Federal Reserve will make equities even moreattractive. The central bank lowered its benchmark lending rateon Sept. 18 by a half-percentage point to 4.75 percent, which helped to fuel the stock-market advance.

`Moving Higher'
A jobs report last week also showed that U.S. employmentincreased by 110,000 jobs in September, while revised figuresfor August showed an unexpected gain of 89,000. The change wipedout what had been the first drop in employment in four years,and lessened concern the six-year expansion will come to an end.``We're going to keep moving higher,'' said Wilson, co-director of equity strategy at Memphis, Tennessee-based MorganKeegan, which manages $120 billion. Investors are "foolishly buying'' protection, he said.

Dean Junkans, who oversees $250 billion as chief investmentofficer at Wells Fargo Private Bank in Minneapolis, says investors are putting too much faith in the Fed keeping theeconomy from slowing. The chance of policy makers cutting ratestwice by December fell to 28 percent last week, fed fundsfutures showed. Two weeks ago, prices reflected a 74 percentchance of two quarter-point rate reductions by year-end.`Hunky Dory'``Just because the Fed lowered rates doesn't mean thateverything is hunky dory,'' said Junkans.

your head and say `Gosh, it's tough to seethat it is,' based on the economic data.''Former Fed Chairman Alan Greenspan said last week that thechances of a U.S. recession have increased and the worst maynot be over'' for the credit markets roiled by subprime defaultsand borrowing costs that rose to a six-year high in September.
David Tice, who runs the $789 million Prudent Bear Fund in Dallas, is more pessimistic. He owns S&P 500 put options becausestocks could ``easily'' decline by more than 50 percent in thenext 12 months to 24 months.Tice says the latest rebound only delays an inevitablecrash, comparing it to when ``somebody falls out of a 95-storybuilding.''``They haven't hit the ground yet,'' he said, ``But they'regetting closer and closer.''

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