Mysterious investor bets $900 million on crash by September 21 - 31-Aug-07 - Generational Dynamics

Generational Dynamics Web Log for 31-Aug-07

Mysterious investor bets $900 million on crash by September 21

Several readers have notified me about this event that has Wall Street buzzing. One reader even suggested that I might be the mysterious investor! Very droll.

My first reaction on reading this story was that, whoever the investor is, he might have seen my web site or, more likely, performed the same computation that I did.

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I arrived at the September 21 date by speculating that the stock market, following its peak on July 19, would follow the same path that it followed after its peak in 1929. This is purely speculative, but it's easy enough for other people to reach the same conclusion.

The news broke on August 21 that someone was making option bets that the S&P index would fall at least 35-40% by September 21. Since that time, speculation has been wild about what's going on. This mysterious person could lose $700-900 million if the market does not fall, but coul make about $2 billion if the market does fall far enough.

So we're talking about real money here. This isn't some flamboyant speculator who wants to impress his girlfriend. This is some major institution that's making a very serious and very huge bet.

There are a variety of explanations, ranging from relatively harmless to a sign of imminent war. Let's take a look at some of them:

One possibility is that it isn't one investor, but a collection of unrelated investors, all of whom share the belief that the market is due for a very big correction.

According to a web site reader: "There are both mutual funds and hedge funds with massive S&P500 exposure in the billions of dollars, if they want to protect themselves, they can sell an out of the money call, and use the money to buy an out of the money put. This insurance basically costs them nothing if the market remains somewhat flat, they get a little protection against a crash, at the expense of limited upside gains if the market climbs a lot. John Hussman of the Hussman Funds does this all the time (buying S&P500 puts as a hedge against his always net long holdings)." (Paragraph added 31-Aug)

It might be a big hedge fund caught in a liquidity crunch, needing money immediately, because their clients are trying to bail out. As I understand it, this could be someone selling "call options" now in order to get cash from market makers (the people who set these deals up), and who will have to pay quite a bit on September 21, when the options come due, if the market doesn't crash. In this scenario, the $900 million bet is actually a move of desperation.

It might be someone who believes that a market correction is due sometime this fall. If it hasn't happened by September 21, then the investor can "roll the options over" for another month or two. There are many people who believe that a big market correction is due, and so this is a reasonably rational thing to do.

It might be China, as part of a strategy either to regain some of hundreds of billions it's loaned to America, or in preparation for war.

It might be some large institution with inside knowledge about some imminent bad news that will move the market sharply down. One theory is the Osama bin Laden himself has placed the bet, expecting to make money from a planned terrorist attack on September 11.

More prosaically, it might be someone with inside knowledge of a major bankruptcy of a large corporation or financial institution. Because of the recent stock market volatility and increasing risk aversion of investors, the investor may be betting that such bad financial news will panic investors.

There's a lot of concern these days that the market is due for a major correction, mainly because it's been so long since the last major correction. Even among those who believe that these times are perfectly normal, there is an expectation of SOME kind of correction, since an occasional correction IS perfectly normal.

However, there really are a lot of people expecting a serious panic these days. One web site reader has just sent me his friend's graph comparing today's stock market with the 1987 stock market panic:

Comparison: 2007 versus Panic of 1987

Comparison: 2007 versus Panic of 1987

The Panic of 1987 was a false panic, since the market was underpriced at the time, so recovery was fairly rapid. (The market today is overpriced by a factor of about 250%, same as in 1929.)

Still, it was a panic, and the market that year followed a pattern similar to this year's pattern.

From the point of view of Generational Dynamics, the panic of 1987 was not a generational panic. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash. We're now overdue for the next one, and it might be close.

Addendum. For those interested in more details, the following is last night's options listings on http://finance.yahoo.com/q/op?s=SPY . The listing is for SPY, corresponding to the S&P 500. Notice the appearance of numerous twelve "10,000"s in the volume column. The mysterious investor has "bet" on almost every strike price from 60 to 95, which correspond to S&P 500 indexes of 600 to 950, respectively. These options are worthless unless the S&P 500 index, currently at 1460, falls into or below the 600-950 range by September 21. Also, a volume figure of 10,000 refers to 10,000 contracts of 100 shares each, or 1,000,000 shares. Since this was done for 12 different strike prices, the "bet" corresponds to 12,000,000 shares. (Paragraph added 31-Aug)

A portion of the SPY (S&P 500 SPDR) options listing for August 30, 2007. <font face=Arial size=-2>(Source: Yahoo)</font>

A portion of the SPY (S&P 500 SPDR) options listing for August 30, 2007. (Source: Yahoo)

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Generational Dynamics Web Log for 31-Aug-07 Mysterious investor bets $900 million on crash by September 21

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Generational Dynamics Web Log for 31-Aug-07
Mysterious investor bets $900 million on crash by September 21