Option Advistor

The following is a reprint of the market commentary from the November edition of the Option Advisor, published on October 23. Prices and the chart are as of the close on October 23. For more information or to subscribe to the Option Advisor, click here.

"In the equity-derivatives market, Berkshire has taken in $4.5 billion in premiums for selling at-the-money puts on the S&P 500 and three foreign equity indexes, with original terms of 15 to 20 years and distant expiration dates between 2019 to 2027. With this bullish bet, Berkshire will pocket the entire premium, plus investment income on the $4.5 billion, if the relevant equity indexes are above where they stood when the company sold the options. A put sale allows Berkshire's counterparty or counterparties to sell the indexes to Berkshire at the option maturity dates. This is a huge option trade because the puts apparently involve a $35 billion notional amount of stock indexes. The trade looks shrewd because these so-called European put options can only be exercised at maturity. Barring a credit downgrade, Berkshire probably doesn't have to post margin collateral against the puts if the trade goes against it in the interim. The odds are the puts will expire worthless, because the S&P and other indexes tend to rise over time."
(Barron's - 3/10/08)

"Buffett's Berkshire equity portfolio, which stood at $69 billion on June 30, is falling in value, although it's ahead of the major averages this year. Berkshire has written, or sold, long-dated put options on some $40 billion of equity indexes, including the S&P 500. Those put sales, which amount to a bullish market bet, are deep in the red, although Berkshire doesn't have to post collateral against any paper losses. We estimate those puts could have cost Berkshire as much as $2 billion in the third quarter and several billion more dollars this quarter, with the S&P down over 20%. Berkshire ultimately may score with these puts if they expire worthless at maturity between 2019 and 2027. But the normally savvy Buffett made a mistake investing in financial derivatives, about which he has long warned. Berkshire had no comment. The brutal market sell-off has stung even famed investors like Buffett."
(Barron's - 10/13/08)

"Presidential rivals John McCain and Barack Obama agreed on at least one thing at last night's debate: Warren Buffett would be a 'good choice' to head the Treasury. What does Buffett have to say about the flattering speculation? When asked if he'd take the post, he simply smiled, according to a Buffett aide cited by the New York Times."
(Dow Jones News Wire - "Market Talk" - 10/8/08)

To summarize the quotes reproduced above, Warren Buffet made a huge and risky bullish bet on the stock market, and it is coming back to haunt him big time as we approach Halloween. Assuming his $35 or $40 billion notional value bullish bet on the S&P was placed during the first quarter of this year, he has since experienced a market plunge of about 33%, plus a devastating tripling of market volatility that compounds the losses on the naked puts that he sold. And while he has plenty of time for the market to right itself and for volatility to return to more normal levels, in the meantime he has probably booked on a "mark to market" basis $5 billion or more in losses on his $4.5 billion "investment."

My point here is that Warren Buffet - the putative bi-partisan choice for Treasury Secretary regardless of which party wins the election and the man who once referred to derivatives as "weapons of mass financial destruction" - in fact fell prey to an overconfidence in the market and an under-appreciation of the potential toxicity of selling derivatives at wholesale prices. In other words, Warren Buffet and the devastated Wall Street firms and the devastated hedge-fund community have a lot in common.

As our own Todd Salamone outlined to Maria Bartiromo on CNBC today, there are 2 huge uncertainties facing the market.

1. No one knows how the credit situation will play out, even with the bailout, and no one knows all the unintended negative consequences of the bailout, which already include a very unwelcome increase in mortgage rates and a rise in the value of the dollar that has further weakened the commodities market and thus contributed to additional devastation of hedge-fund portfolios. To put the extent of the potential credit loss exposure in mind-boggling perspective, Christopher Cox, Chairman of the SEC, stated the following in an op-ed piece in the 10/19/08 edition of The New York Times: "A.I.G. had issued $440 billion in credit-default swaps - which are like insurance contracts on bonds and other assets that are meant to pay off if those assets default. But as markdowns on A.I.G.'s investments in subprime mortgages led to downgrades in its credit ratings, the holders of the credit-default swaps demanded more collateral, which A.I.G. could not provide. As large as A.I.G.'s swaps exposure was, it represented only 0.8 percent of the $55 trillion in credit-default swaps outstanding - this total market is more than the gross domestic product of all nations on earth combined."
2. No one knows how much more hedge fund unwind there is going to be of their heavy long exposure in such sectors as commodities and technology, due to an ongoing vicious circle of devastating market losses leading to investor redemptions leading to forced liquidations and to further investor redemptions. This was a $2-trillion market player at the beginning of this year - that exerted an even greater impact on the market due to huge portfolio turnover and leverage - that is already well on its way to imploding. And it may be far from over. "The chief executive of a leading alternative investment manager said he expected the hedge fund industry to shrink by 50 per cent in coming months - with half the decline coming from withdrawals and half coming from investment losses," according to the Financial Times of 10/16/08.

While many will equate uncertainty with opportunity, it is actually unfortunate for the prognosis for this market that so many are doing so at this time. Yes, there is fear out there, and certainly there is panic on individual days, but the talking heads and the typing heads and the bloggers have had a strong tendency to tell us it is too late to sell and that there is "value" out there. The much-cited spike in the CBOE Market Volatility Index (VIX) and its validity as a "fear gauge" has been compromised by the fact that VIX levels have actually been tracking (and, for the most part, trailing) actual market volatility. And our proprietary equity put/call ratio, as well as that of the International Securities Exchange that tracks "buy to open" option activity, have been reflecting a less-than-impressive degree of put activity relative to call activity given the devastation in the market.

And speaking of market devastation, I placed a very high degree of importance in my October commentary in this space on the importance of the S&P 500 Index (SPX) holding at support at its 160-month moving average, as it had at the 2002-2003 market bottoms. But today the S&P closed about 20% below this key moving average, which is currently at about 1,127.

So where do we go from here? The market is certainly "oversold" and could bounce hard, as evidenced by the fact that the 14-week Relative Strength Index of the S&P has moved well below its July 2002 low. And there are some round-number levels that could hold as support, such as 500 on the Russell 2000 Index and 30 on the ProShares QQQ Trust. But I would remain quite defensive, looking to hedge any long stock exposure with shorts or with put positions on exchange-traded funds (ETF), including the "double inverse" ETFs on such still-vulnerable sectors as energy and technology.

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