VIX Premium Shows Stocks Bear Market Lasting 2 Years (Update1)

March 2 (Bloomberg) — Options investors are paying twice this decade’s average to protect against losses in U.S. stocks through 2011, signaling the bear market that already wiped out $10.4 trillion of equity value may last two more years.

“There’s a real panic in the markets, with some people wanting to buy long-term insurance at any price,” said Peter Sorrentino, who helps manage $16 billion, including $130 million in options at Huntington Asset Advisors Inc. in Cincinnati. “People have lost hope.”

Contracts to protect against a decline in the Standard & Poor’s 500 Index for two years cost $15,160 on the Chicago Board Options Exchange, compared with $6,875 in 2007, according to price-adjusted data compiled by Bloomberg. Today’s level shows traders expect the benchmark gauge for U.S. equities to fluctuate twice as much in the next two years as it has since 2000.

Federal Reserve Chairman Ben S. Bernanke said last week the economy is in a “severe contraction” that may continue to next year unless actions to save the financial system start working. The S&P 500 lost 53 percent since peaking in October 2007 while retreats in commodities and corporate bonds drove 920 hedge funds, or 9 percent of the total, out of business last year.

Options traders see little chance of relief, based on the so-called implied volatility of two-year contracts on the S&P 500. It jumped to a record 43.58 in November and stayed above 30 since then, a level it never previously exceeded, according to data compiled by Bloomberg and IVolatility.com, a New York-based provider of options data. Implied volatility is the main variable in determining an option’s price.

Biggest Swings

The S&P 500 slipped 4.5 percent last week to a 12-year low of 735.09 after the federal bailout of Citigroup Inc. reduced shareholders’ stake in the bank and a report showed the U.S. economy contracted more than forecast in the fourth quarter. The implied volatility of two-year options closed at 36.08, little changed from a week earlier.

Futures on the S&P 500 fell 1.9 percent to 720.10 at 10:20 a.m. in London after Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc., said in his annual letter to shareholders released Feb. 28 that the economy will be “in shambles” this year, and perhaps longer.

Levels of volatility show traders are using options to prepare for the longest bear market since 2002. They’re at odds with the prevailing view of Wall Street strategists, who forecast the S&P 500 will rebound 37 percent to end the year at 1,010, based on 10 estimates compiled by Bloomberg News.

Nowhere to Hide

More than $1.1 trillion in bank losses and writedowns froze lending in 2008, pushing volatility in the S&P 500 to a record high and sending 62 of 68 industries lower. The intraday fluctuation in the index grew as wide as 11 percent on Oct. 28, panicking investors. On a closing basis, the gauge moved more than 5 percent on 18 days last year. Before 2008, it hadn’t risen or fallen that much since July 29, 2002, according to data compiled by Bloomberg.

Investors had little refuge other than Treasuries last year, as 10-year government notes gained 14 percent in 2008, according to Merrill Lynch & Co. index data.

Corporate bonds with investment-grade credit ratings fell 6.8 percent, according to Merrill. The Reuters/Jefferies CRB Index of commodity prices tumbled 36 percent, the most in its history stretching back to 1957. The average hedge fund lost 23 percent, the steepest drop on record, according to Chicago-based Hedge Fund Research Inc.

‘Volcano, Hurricane’

Two-year options show the same level of concern as one-month contracts signaled when Bear Stearns Cos. collapsed in March and Lehman Brothers Holdings Inc. fell apart six months later. The Chicago Board Options Exchange Volatility Index, reflecting the price for 30-day S&P 500 contracts, closed at 32.24 and 31.70, respectively, after the Fed helped New York-based JPMorgan Chase & Co. bail out Bear Stearns in March and Lehman Brothers folded in September.

“There’s a new appreciation for the risk of extreme and unlikely events,” said Michael McCarty, chief equity and options strategist at Meridian Equity Partners Inc. in New York. The increase in volatility “was an earthquake, volcano, hurricane and tsunami all at once,” he said.

Investors use options to protect against weakening asset prices as well as speculate on fluctuations. Calls give the right to buy a security for a certain amount by a given date. Puts convey the right to sell.

Prices for longer-term options are elevated in part because fewer investment banks and hedge funds are selling the contracts, according to strategists at New York-based Morgan Stanley, Paris- based BNP Paribas and Russell Investments of Tacoma, Washington.

‘Price of Insurance’

“We would expect a sustained higher level of implied volatility until more sellers enter the marketplace,” said Jody Smith, a London-based volatility trading analyst at Russell, which oversees $150 billion. “When the number of insurance companies goes from 100 to 50, the price of insurance is going to go up.”

Dealers are selling fewer contacts after 2008’s rout broke a 17-year stretch in which making markets in options earned money. The Merrill Lynch Equity Volatility Arbitrage Index, which gauges the profitability of selling options by comparing implied and realized volatility, plunged 69 percent in September to November.

Gervais Williams, who manages about $1.2 billion in stocks at Gartmore Investment Management in London, said he used options at least a year from expiration to hedge a 50 million pound ($72 million) fund in July 2007, just before losses on bonds backed by U.S. subprime mortgages brought credit markets to a halt.

‘Credit Crunch’

“We were concerned equity markets were going to run out of room, that some kind of credit crunch was about to happen,” Williams said. The positions netted him more than 15 million pounds in profit, he said.

Two years ago, Bernanke predicted that “moderate” economic growth in 2007 would be followed by an accelerating expansion in 2008. Instead, the U.S. joined Europe and Japan in the first simultaneous recessions since World War II. Bernanke said Feb. 24 that “downside risks probably outweigh those on the upside” and the Fed’s outlook is clouded by “considerable” uncertainty.

“The market expects further unforeseen shocks,” said Simon Emrich, head of North American quantitative derivatives strategies at Morgan Stanley in New York.

John Bogle, who created the $68.8 billion Vanguard 500 Index Fund, said in a Bloomberg Television interview from Washington on Feb. 24 that the U.S. recession may linger into 2011. Bank of England policy maker David Blanchflower predicted a day later that the slump in the U.K. might intensify “significantly.”

‘Medication Runs Out’

Two-year volatility dropped 14 percent from its record in November, compared with a 45 percent retreat in 30-day volatility. The difference shows that confidence in the market’s direction over one month has improved while concern about longer- term swings remains elevated, said Paul Britton, chief executive officer of New York-based Capstone Holdings Group, which specializes in volatility trading.

“The market is subdued now because we have enough morphine in our system that we won’t see the spikes we did in October and November,” Britton said. “The uncertainty comes when the medication runs out.”

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