Stocks in U.S. Poised for 10 Percent Drop, Options Bets Show By Nick Baker and Michael Tsang July 16 (Bloomberg) -- Bets in the options market against the Standard & Poor's 500 Index have exceeded wagers it will rise by a 2-to-1 margin for a month, the longest since Bloomberg began compiling the data in 1995. That's seen as a warning sign the market is due for a decline of 5 to 10 percent after the S&P 500 rose to two records last week, say managers of almost $1 trillion at Morgan Stanley Global Wealth Management, National City Private Client Group and Russell Investment Group. The Leuthold Group, whose flagship fund has beaten 99 percent of similar funds over the last five years, expects the S&P 500 to slide as much as 19 percent by the end of the year. The options market is ``a bell ringer,'' said David Darst, who oversees $728 billion as chief investment strategist at New York-based Morgan Stanley's private banking unit. ``On a short- term basis, the market's ahead of itself and could have a pullback.'' Darst, who cashed in some stocks in the past 12 months, said the market could drop as much as 10 percent. The increase in so-called put options coincides with analysts' outlook for the worst corporate earnings since 2002. Retail sales slid in June by the most in almost two years, a signal that near-record gasoline prices and falling home values are taking a bigger toll on consumers than economists had forecast. Bears Come Out ``People are starting to realize that in the second quarter we're not going to have blowout earnings,'' said Nick Raich, Cleveland-based director of research at National City, which manages $34 billion. ``The bears could come out of the woodwork.'' Raich, whose firm cut its stock allocation in May, said the options trading shows investors expect the market to fall 5 to 10 percent. He personally focuses more on earnings as an indicator of where the market is headed. Members of the S&P 500 increased profit by at least 10 percent in every quarter since the third quarter of 2002, fueling the index's 57 percent advance to an all-time high. Analysts estimate that second-quarter profit at S&P 500 members climbed 4.8 percent, according to a Bloomberg survey. In the past month, they've reduced forecasts for six of 10 industry groups in the index. Analysts' projections for so-called consumer discretionary stocks, which include the majority of retailers, dropped the most. Atlanta-based Home Depot Inc., the world's largest home- improvement retailer, last week cut its profit outlook, citing a deepening housing slump. Shares of Hoffman Estates, Illinois- based Sears Holdings Corp., the biggest U.S. department-store company, tumbled the most in more than four years on July 10 after predicting a decline in profit of as much as 46 percent. Puts and Calls Concern that earnings will slow has undermined some investors' conviction that the bull market will continue, prompting them to buy insurance in the options market. Puts convey the right, without the obligation, to sell a security at a set price by a given date. Calls give investors the right to buy. So-called open interest, or the number of contracts held, for puts on the S&P 500 and an exchange-traded fund linked to the index reached 10.4 million on June 19. That was 2.24 times the number of calls, the most since August 1998. Twice as many puts relative to calls have been owned during the 20 trading sessions beginning on June 15. The figure stood at 2.03 at the end of last week. The ratio was 1.24 on Oct. 9, 2002, when the bull market began. ``People are buying puts because they think the market is going to go down,'' said Stephen Wood, New York-based senior portfolio strategist at Russell Investment, which oversees more than $200 billion. Wood said he wouldn't be surprised to see the market fall 5 percent. `Good Hedge' Investors are buying the put options as protection from the crisis in housing, said Joseph Quinlan, chief market strategist at Bank of America's investment strategy group in New York. S&P last week cut credit ratings on $6.39 billion of bonds backed by subprime mortgages, or those to people with poor or limited credit. Moody's Investors Service also reduced ratings on about $5 billion of debt backed by subprime mortgages and Fitch Ratings said it may cut $7.1 billion on expectations home- loan defaults will increase. ``No one really has a firm grip yet how much this subprime issue is going to mushroom or morph into something that's completely different and much more extensive,'' said Quinlan. ``Puts are a good hedge against that kind of possibility.'' Bank of America's investment-management unit oversees $547 billion. Benjamin Pace, chief investment officer at Deutsche Bank Private Wealth Management in New York, reads the options market differently. He says the surge in bearish options bets may be a sign U.S. stocks will extend their all-time highs. `Reverse Indicator' The ratio of puts to calls is ``usually a good reverse indicator,'' said Pace, whose firm manages about $50 billion. Shares have continued to rally this year in spite of obstacles such as subprime mortgages, he said. ``The market's shown resiliency,'' and U.S. stocks may return as much as 13 percent over the next year, he said. David Dreman, who oversees almost $23 billion at Dreman Value Management LLC in Jersey City, New Jersey, said subprime loans may be the catalyst for a market slump. ``I wouldn't be surprised by a correction in the next six to eight months,'' said Dreman, whose flagship fund has beaten the S&P 500 for seven straight years. ``A 5 percent to 10 percent drop is certainly possible.'' `Really Behind Us' Profit forecasts at S&P 500 companies this quarter may also be too low, if history is any guide. Analysts underestimated operating profit growth for S&P 500 companies in the past 15 quarters, figures compiled by Bloomberg and Venice, Florida- based Ned Davis Research Inc. show. Investors shouldn't expect similar surprises this time, said Andy Engel, co-manager of the $1.73 billion Core Investment Fund at the Leuthold Group in Minneapolis. A ratio tracked by Leuthold of U.S. companies reporting year-on-year profit increases compared with the number posting earnings declines is already the ninth lowest in the 23-year history of the firm's data. ``The best times are really behind us, and going forward you're going to see probably more and more disappointments,'' Engel said. Leuthold took out so-called shorts that equaled 12 percent of assets in its core fund about five weeks ago. A short sale is the practice of selling borrowed shares on the bet prices will decline and the seller will profit from the difference. `Catching a Cold' The length of time since the last market decline of 10 percent or more only increases the likelihood of such a slump, according to Morgan Stanley Global Wealth's Darst. ``I wouldn't be surprised if we get one of those 10 percent corrections,'' Darst said from Anchorage, Alaska. The S&P 500 last dropped that much four years ago, when the index tumbled 15 percent during the three months before the U.S. invasion of Iraq. ``The market's ahead of itself,'' Darst said. ``We haven't had a market catching a cold or having a fever that would cause it to calm down a bit.'' At the end of the second quarter, 32.6 percent of investment newsletter writers forecast a correction in U.S. stocks during the next year, according to a survey by Investors Intelligence. That was the highest since August 1997, the New Rochelle, New York-based company's data showed. Investors aren't just using put options to wager against the market. Hedge funds are short-selling S&P 500 futures by the most in three years, New York-based Merrill Lynch & Co.'s Mary Ann Bartels said last week. She cited data from the Commodity Futures Trading Commission, a government agency located in Washington. ``I am nervous that we've gone so long without a correction,'' said Nick Sargen, who helps oversee about $30 billion as chief investment officer at Fort Washington Investment Advisors in Cincinnati. ``We haven't had one in four years. That's a very, very unusual set of circumstances.''