Options traders bet against Dow advance

Options traders are increasing bets that the steepest rally in the Standard & Poor’s 500 Indexsince the 1930s won’t surviveSeptember, historically the worst month for U.S. equities.

Traders were betting the VIX, a gauge of expected stock swings, would increase 13 percent in the next five weeks, according to futures prices at the end of last week compiled by Bloomberg. That’s the biggest spread since August 2008, before the S&P 500 suffered the steepest two-month plunge in 21 years. The indexes have moved in the opposite direction 81 percent of the time over the past five years, Bloomberg data show.

VIX futures above the level of the index show investors expect fluctuations to widen and stocks to retreat. The S&P 500 has rallied 49 percent in five months, pushing valuations to the highest levels since December 2004. The S&P 500 gained 2.3 percent last week as reports showed home sales rose and theunemployment rate fell.

“It’s a danger sign,” said Ronald Egalka, a 36-year options trader who oversees $8 billion as chief executive officer of Rampart Investment Management in Boston. “People expect volatility to pick up in the future, and that implies that there’s going to be a downward movement in the market.”

History shows that U.S. investors lose the most in September. The benchmark index for American equities fell 1.3 percent on average since 1928 that month, data compiled by Bloomberg show.

30% Slump

The S&P 500 lost 0.2 percent to 1,008.54 at 11:20 a.m. in New York. Mark Mobius said global stocks will drop as much as 30 percent following their recovery from last year’s rout as companies take advantage of the rebound to sell more shares.

“When you have these rapid increases almost without correction, you will definitely have a correction,” Mobius, who oversees about $25 billion as executive chairman of Templeton Asset Management Ltd., said in an interview in Kuala Lumpur today. “We can expect a lot of volatility.”

The S&P 500 plunged 9.1 percent last September after New York-based Lehman Brothers Holdings Inc. collapsed. The biggest drop occurred in September 1931 during the Great Depression, when the S&P 500 tumbled 30 percent. February is the only other month when stocks fell on average since 1928, losing 0.3 percent, Bloomberg data show.

Buying Insurance

The VIX, as the Chicago Board Options Exchange Volatility Index is known, usually moves in the opposite direction of the S&P 500 because demand for insurance rises as stocks fall. VIX futures expiring in September were 3.29 points higher than the index on Aug. 7, and last month were as much as 5.91 points higher, a record gap for so-called second-month contracts. Last week’s spread was comparable to the one in August 2008.

The VIX added 2.1 percent to 25.28 today, while the September futures contract fell 0.1 percent to 28.03.

The index has averaged 20.22 over its 19-year history and surpassed 50 for the first time in October after Lehman filed for the biggest U.S. bankruptcy.Frozen credit markets and bank losses approaching $1 trillion tied to subprime loans pushed the measure to a record 89.53 on Oct. 24. Losses at the world’s biggest financial companies now exceed $1.5 trillion, according to Bloomberg data.

Last week’s reading indicated a 68 percent likelihood the S&P 500 would fluctuate as much as 7.2 percent in the next 30 days, according to data compiled by Bloomberg.

‘Break in the Market’

“VIX futures are telling you that investors are willing to pay a premium forprotection,” said David Palmer, who helps oversee $300 million as volatility portfolio manager at Hudson Bay Capital Management LLC, a New York-based hedge fund that returned 11 percent last year, according to Absolute Return magazine. “People expect some sort of a break in the market.”

Hedge funds lost an average 18.3 percent in 2008, according to Chicago-based Hedge Fund Research Inc. The S&P 500 declined 38 percent, the worst performance since 1937.

Options strategists saw the same upward-sloping curve last August, before the S&P 500 tumbled 9.1 percent in September and 17 percent in October. VIXfutures two months from expiration were 4.11 points higher than the VIX on Aug. 22, when the index slumped to an 11-week low of 18.81.

Volatility may be increasing for reasons unrelated to stock prices, according to Macro Risk Advisors LLC, a New York-based options brokerage. Traders who sold bullish options when the rally began on expectations the gain would fizzle may be buying them back now, Dean Curnutt, the firm’s president, wrote in a note. That demand could be artificially boosting the VIX.

Beating Estimates

U.S. companies are also beating analysts’ earnings estimates at an almost record rate, making investors more bullish, according to Rob Morgan, who helps oversee $6 billion as market strategist at Clermont Wealth Strategies in Lancaster, Pennsylvania.

For the second quarter, 72.2 percent of S&P 500 companies surpassed consensus estimates for profit, just below the 72.3 percent ratio five years ago that was the highest since at least 1993, data compiled by Bloomberg show.

Investors still hold more than $3.6 trillion of their assets in money-market funds, equal to about 30 percent of the total market capitalization of U.S. companies, according to data compiled by the Washington-based Investment Company Institute and Bloomberg. That’s double the percentage when the S&P 500 reached its all-time high in October 2007, the data show.

Home Sales, Unemployment

The number of contracts to buy previously owned homes in the U.S. rose 3.6 percent in June, the fifth straight monthly increase and more than economists estimated, as lower prices and mortgage rates lured buyers, the National Association of Realtors said Aug. 4. The unemployment rate fell for the first time in more than a year, dipping to 9.4 percent from a 26-year high of 9.5 percent, the Labor Department said Aug. 7.

“There’s a good underpinning to the market here, and the VIX is just one tool in the toolbox,” Morgan said. “Stocks follow earnings and revisions are going up and you also have a boatload of cash still sitting on the sidelines as the economy is turning.”

The S&P 500 will keep rallying this year as exports to expanding Asian economies help U.S. companies boost profits, David Bianco, the chief U.S. equity strategist at Bank of America Corp., wrote in a report today.

Bianco said S&P 500 companies will earn $59 a share this year, tying him with Credit Suisse Group AG’s Andrew Garthwaite for the highest estimate among 11 strategists that Bloomberg tracks who have 2009 profit projections. Bianco is based in New York, while Garthwaite is in London.

‘Pause in September’

Paul Tudor Jones, the hedge fund manager whose $8.9 billion Tudor BVI fund gained 10 percent this year through July, said he expects that global stocks may “pause in September” on slower Chinese economic growth. The advance since March is a “bear- market rally,” Jones wrote in a report to clients last week. “We are not inclined to aggressively chase the market here.”

The S&P 500 traded for 18.6 times its companies’ average earnings this year at the end of last week, the highest since December 2004, according to data compiled by Bloomberg.

The first global recession since World War II may worsen as more Americans get thrown out of work and the benefits of government spending wear off, according to Martin Feldstein of Harvard University.

“There is a real danger this is going to be a double dip and that after six months or so we’ll have some more bad news,” Feldstein, the former head of the National Bureau of Economic Research, said on Bloomberg Television last month. “We could slide down again in the fourth quarter.”

Better Than Estimated

The U.S. economy contracted at a 1 percent annual pace in the second quarter, less than economists forecast, as government spending increasedthe most since 2003. The outlays, part of President Barack Obama’s $787 billion stimulus package approved in February, masked a 1.2 percent drop in consumer spending, which accounts for more than two-thirds of the economy.

Almost half of U.S. homeowners with a mortgage are likely to owe more than their properties are worth before the housing recession ends, Karen Weaverand Ying Shen, New York-based analysts at Deutsche Bank AG, wrote in a report dated Aug. 5.

The percentage of “underwater” loans may rise to 48 percent, or 25 million homes, as prices drop through the first quarter of 2011, according to Frankfurt-based Deutsche Bank. As of March 31, the share of homes mortgaged for more than their value was 26 percent, or about 14 million properties.

61% Surge in Profit

Profit for companies in the S&P 500 will fall 22 percent this quarter before an earnings rebound by financial institutions spurs a 61 percent increase in the last three months of the year, according to analysts’ estimates. Excluding banks, brokerages and insurance companies, profits are projected to drop 8.6 percent in the fourth quarter.

U.S. stock trading has also slowed by the most in at least two decades. An average of 1.34 billion shares changed hands daily on the New York Stock Exchange between May 1 and Aug. 7, about 16 percent less than the average from Jan. 1 to April 30. That’s the biggest drop since at least 1989, according to data compiled by Harrison, New York-based research firm Bespoke Investment Group LLC.

“There’s always a real risk that a rally is going to be tested,” said Stephen Wood, New York-based chief market strategist for North America at Russell Investments, which had $151.8 billion in assets under management as of June 30. “Investors are thinking that giving up some upside to hedge the downside is a very reasonable investment profile.”