Over the past few days, there have been several stories written about Warren Buffetts $14 billion bet on global stock markets. I believe these stories are all in reference to this excerpt form Berkshire Hathaways annual report:

Berkshire is also subject to equity price risk with respect to certain long duration equity index put contracts. Berkshires maximum exposure with respect to such contracts is approximately $14 billion at December 31, 2005. These contracts generally expire 15 to 20 years from inception. Outstanding contracts at December 31, 2005, have been written on four major equity indexes including three foreign. Berkshires potential exposure with respect to these contracts is directly correlated to the movement of the underlying stock index between contract inception date and expiration. Thus, if the overall value at December 31, 2005 of the underlying indices decline 30%, Berkshire would incur a pre-tax loss of approximately $900 million.

Its impossible to evaluate what exactly this means for Berkshire or what it tells us about Buffetts thinking without knowing more details. But, there are a few things Id suggest you consider when reading the news reports.

First, the $14 billion headline number makes this bet look larger than it really is. According to the above disclosure, a 30% decline in the underlying indices would only create a $900 million pre-tax loss. One article stated that a decline in the indexes to zero was highly unlikely given historical trends. Its a lot more than highly unlikely. But, since we dont know the details of Berkshires exposure, we cant evaluate the real risk of a very large loss.

A lot of these news stories have called Berkshires long duration equity index put contracts a bet on global stock markets. A few individuals have been quoted as saying Buffett has become bullish long-term. Buffetts always been optimistic about the very long-term insofar as he recognizes how better things are today than they have been at any other time in history, and how that is likely to remain true for some time. Despite Buffetts concerns about nuclear war, he doesnt see a return to the Dark Ages and those kinds of anemic returns on capital.

Thats important to keep in mind, because Im not sure this bet is much more than that. If you assume returns on equity will be similar to those achieved in the years since industrialization began, and you assume central governments will continue to cause inflation, a long duration equity index put contract isnt much of a stretch.

Equity will earn returns, much of those returns will be retained by the businesses, and inflation will increase (nominal) stock prices regardless of whether the underlying businesses assets are increasing or remaining stable.

So, Im not sure this is a bullish sign. In fact, it may be a bearish sign, because it suggests Buffett cant find individual equities to buy, three of the four indexes are foreign, and someone wants to be protected against very large losses in a diversified group of holdings.

Remember, someone is paying for this protection. In my opinion, its not the kind of protection investors need. Its long-term protection on an index. I suppose I can see why a pension fund might want this (to increase exposure to equities), but it seems like exactly the sort of thing an insurance company can make money selling. Theres fear of a very large loss, and a lot of factors that are hard to see that will tend to make that loss pretty unlikely.

We dont know what premiums Berkshire is receiving, so we really cant evaluate these contracts. If someone writes hurricane insurance it doesnt mean they think hurricanes are unlikely, it just means they think someone is dumb enough to pay more than the protection is worth. Knowing the odds of a decline in global stock markets isnt enough to evaluate Berkshires contracts, because we dont know the price.

Im not enamored with current valuations in the U.S., but looking out a couple decades its not all doom and gloom. Markets tend to overshoot in both directions, but theres usually someone sane enough to buy when stocks get cheap enough.

Whats remarkable about the way investors move stock prices isnt the magnitude of the truly major moves (up or down); its the frequency of meaningful moves when theres no meaningful changes in underlying values. Think about the price range of an average stock in an average year thats the really irrational part of investor behavior. I wouldnt want to have anything to do with a one-year contract on a single stock. Thats a very different situation.