Bearish Bets Against Markets Are Surging

Investors are wagering that the recent pain in markets will intensify.

Stocks dropped sharply in another wild session Tuesday after Russia deployed troops into two breakaway areas of Ukraine, escalating tensions in the region. The S&P 500 ended the day down 1%, extending the losses from its January record to more than 10% and meeting the criteria of a market correction. The index hadn’t suffered a similar decline since February 2020.

Short sellers have been adding to their positions against the SPDR S&P 500 Exchange-Traded Fund Trust, which tracks the broad U.S. stock index, at the fastest rate in nearly a year. Other investors are scooping up at record pace options contracts that would pay out if the recent declines in the stock and bond markets worsen.

The escalating geopolitical tensions come at a time when a surge in inflation and uncertainty about the pace of the Federal Reserve’s expected interest-rate increases have already whipsawed financial markets to start the year. Earnings growth, meanwhile, is expected to moderate from its red-hot pace in 2021, when profits were being compared with their knocked-down levels during the early stages of the pandemic.

The S&P 500 is down 9.7% in 2022, while the tech-heavy Nasdaq Composite has tumbled 14%. In the bond market, benchmark borrowing costs rose above 2% earlier this month for the first time since mid-2019.

“Sentiment is really poor,” said Danny Kirsch, head of options at Piper Sandler, who said he has noticed more clients opting for hedges recently. “People are nervous.”

Short sellers added $8.6 billion to their positions against the SPDR S&P 500 ETF Trust over the four weeks through Thursday, according to projections from technology and data analytics company S3 Partners. That amount would be the highest since a four-week period ending in early March 2021.

Short sellers borrow shares and sell them, with a plan to repurchase them at lower prices and pocket the difference. Investors shorting the market may be placing an outright bet that stocks will fall or reducing their exposure to a market downturn while betting that particular stocks will outperform.

Jordan Kahn, chief investment officer at ACM Funds, said his firm has been trimming its positions in stocks in one of its strategies while adding to short positions against exchange-traded funds that track the broad market.

Mr. Kahn said he grew concerned near the end of 2021 when he saw that individual stocks were selling off, while the largest stocks kept major indexes afloat.

“That’s kind of a red flag for us,” he said. “We think that the most likely scenario is that those big stocks that haven’t had as big a correction yet will probably at some point play catch-up to the downside.”

Investors are loading up their bets against a number of big tech stocks that led the way higher in recent years, positioning for a reversal. Investors added $1.3 billion to their short positions against Tesla Inc. over the 30 days through Friday and almost $844 million to their bets against Nvidia Corp., according to S3 Partners. They have been trimming their bets, by contrast, against Bank of America Corp., Apple Inc. and Texas Instruments Inc.

Nvidia shares have fallen 20% in 2022 but are still up 63% over the past year. Tesla is down 22% this year but is up 15% from a year ago. Both stocks have skyrocketed since the end of 2019.

Many traders have stepped in to buy the stock market dips, despite the volatility. However, traders have also been tapping other options strategies to profit from the downturn or hedge their portfolios. Three out of five of the most active days for put options trading in history have occurred in the first weeks of 2022, according to Cboe Global Markets data as of Friday.

Call options on single stocks as a percentage of total options activity recently fell to the lowest level since April 2020, when the Covid-19 pandemic was first spreading through the U.S., according to Goldman Sachs Group Inc.

For much of last year, turbocharged bullish bets on stocks were in vogue, and many traders rode the S&P 500’s ascent to 70 fresh highs.

Calls give the right to buy shares at a later time, by a stated date. Puts confer the right to sell.

Investors are also hedging against potential declines in the bond market. The prospect of higher interest rates has triggered a rush out of bonds, with outflows from money-market and bond funds on pace to be the biggest in at least seven years.

The number of put options outstanding tied to the iShares iBoxx $ High Yield Corporate Bond ETF, which goes by the ticker HYG, and iShares iBoxx $ Investment Grade Corporate Bond ETF, or LQD, recently jumped to the highest level on record, according to Barclays PLC.

To some traders, the dour sentiment can be an opportunity to capitalize on any rebound.

Julien Stouff, founder of hedge-fund firm Stouff Capital in Geneva, Switzerland, said he placed short-term bullish bets on stocks in January around the time he noticed many traders growing more pessimistic on the market. Recently, he has taken a neutral stance through the options market.

“This fear normally creates a buying opportunity,” he said.

Berkshire began liquidating its big stake in the banking company in mid-July—and has already unloaded about 15% of its interest. The selling has been fairly aggressive and has totaled about $6 billion. (Berkshire still holds 883 million shares, an 11.3% interest worth $35 billion based on its most recent filing on Aug. 30.)

The selling has prompted speculation about when CEO Warren Buffett, who oversees Berkshire’s $300 billion equity portfolio, will stop. The sales have depressed Bank of America stock, which has underperformed peers since Berkshire began its sell program. The stock closed down 0.9% Thursday at $40.14.

It’s possible that Berkshire will stop selling when the stake drops to 700 million shares. Taxes and history would be the reasons why.

Berkshire accumulated its Bank of America stake in two stages—and at vastly different prices. Berkshire’s initial stake came in 2017 , when it swapped $5 billion of Bank of America preferred stock for 700 million shares of common stock via warrants it received as part of the original preferred investment in 2011.

Berkshire got a sweet deal in that 2011 transaction. At the time, Bank of America was looking for a Buffett imprimatur—and the bank’s stock price was weak and under $10 a share.

Berkshire paid about $7 a share for that initial stake of 700 million common shares. The rest of the Berkshire stake, more than 300 million shares, was mostly purchased in 2018 at around $30 a share.

With Bank of America stock currently trading around $40, Berkshire faces a high tax burden from selling shares from the original stake of 700 million shares, given the low cost basis, and a much lighter tax hit from unloading the rest. Berkshire is subject to corporate taxes—an estimated 25% including local taxes—on gains on any sales of stock. The tax bite is stark.

Berkshire might own $2 to $3 a share in taxes on sales of high-cost stock and $8 a share on low-cost stock purchased for $7 a share.

New York tax expert Robert Willens says corporations, like individuals, can specify the particular lots when they sell stock with multiple cost levels.

“If stock is held in the custody of a broker, an adequate identification is made if the taxpayer specifies to the broker having custody of the stock the particular stock to be sold and, within a reasonable time thereafter, confirmation of such specification is set forth in a written document from the broker,” Willens told Barron’s in an email.

He assumes that Berkshire will identify the high-cost Bank of America stock for the recent sales to minimize its tax liability.

If sellers don’t specify, they generally are subject to “first in, first out,” or FIFO, accounting, meaning that the stock bought first would be subject to any tax on gains.

Buffett tends to be tax-averse—and that may prompt him to keep the original stake of 700 million shares. He could also mull any loyalty he may feel toward Bank of America CEO Brian Moynihan , whom Buffett has praised in the past.

Another reason for Berkshire to hold Bank of America is that it’s the company’s only big equity holding among traditional banks after selling shares of U.S. Bancorp , Bank of New York Mellon , JPMorgan Chase , and Wells Fargo in recent years.

Buffett, however, often eliminates stock holdings after he begins selling them down, as he did with the other bank stocks. Berkshire does retain a smaller stake of about $3 billion in Citigroup.

There could be a new filing on sales of Bank of America stock by Berkshire on Thursday evening. It has been three business days since the last one.

Berkshire must file within two business days of any sales of Bank of America stock since it owns more than 10%. The conglomerate will need to get its stake under about 777 million shares, about 100 million below the current level, before it can avoid the two-day filing rule.

It should be said that taxes haven’t deterred Buffett from selling over half of Berkshire’s stake in Apple this year—an estimated $85 billion or more of stock. Barron’s has estimated that Berkshire may owe $15 billion on the bulk of the sales that occurred in the second quarter.

Berkshire now holds 400 million shares of Apple and Barron’s has argued that Buffett may be finished reducing the Apple stake at that round number, which is the same number of shares that Berkshire has held in Coca-Cola for more than two decades.

Buffett may like round numbers—and 700 million could be just the right figure for Bank of America.

Bearish Bets Against Markets Are Surging

Investors are loading up their bets against a number of big tech stocks, positioning for a reversal.

When will Berkshire Hathaway stop selling Bank of America stock?