Canary or Canard?

Earlier in the week, I introduced a ratio chart of the percentage of S&P500 stocks above their 50 day SMA divided by the VIX. I described this as an attempt to find a rough approximation of greed ÷ fear. Since this chart received some favorable reviews, let me unveil another VIX ratio chart that attempts identify the same market sentiment extremes and provide a warning about the increased probability of near-term market highs and lows.

The chart below is a weekly chart of the ratio of the new 52 week highs in the NYSE divided by the VIX. I focus primarily on the raw number and the 4 week SMA. You can see from the chart that raw reading above 30 and a 4 week SMA readings above 20 tend to signal that a top is near.

In fact, this chart provided excellent advance notice of the 2/27/07 top, the 5/11/06 top, and previous tops in March 2004 and March 2005. With bottoms, the record is not quite as good, with an excellent advance call of the October 2005 low, but calls that were too early for May-July 2006, March-August 2004, and July 2002-March 2003.

You can decide if this ratio chart deserves a spot in your toolbox or bird cage or whatever it is that you use to try to divine the future. For me, it’s a keeper.

The Credit Default Swap Canary

Raise your hand if you were following were watching the Bombay Sensex for clues about the future of the Chinese market or were wise to the unwinding of the Yen carry trade before it happened. Maybe you were tipped off to the subprime mortgage debacle. If so, you did a better job than most investors.

I won’t say that keeping a weather eye on the VIX would have guaranteed that you found yourself on the right side of the markets on 2/27, but it would have helped. Careful study of the equity put to call ratio would also probably have helped.

Let me nominate another canary to add to the investment coal mine: credit default swaps. I know, I’m not a bond guy either, but keeping an eye on how the markets are pricing default risk (the spread versus the US Treasury yield curve) is somewhat of a bond analog for how equity risk is priced in with the VIX.

I highly recommend watching the credit default swap index for high yield corporate bonds. A snapshot of this index is available at Yahoo, but much more information is available through Markit (click on the Dow Jones CDX.NA.HY link to pull up the graph below). Note that in the high yield graph, the market discounted 1/3 of the risk premium from September to Feburary and is now going through wild gyrations in an effort to re-price the risk premium to better match current expectations.

I should also note that while StockCharts.com does not provide charts for the high yield credit default index, they do offer charts for a sister index, the investment grade credit default index, whose weekly chart I have included below. The IG index chart suggests that the recent turmoil in the bond markets is less than what transpired during the May-July sell-off of last year and does little to reverse the 20 month trend of increasingly narrowing credit default spreads.

The bottom line is that it is always good to have a canary that you watch closely to help call market tops and bottoms. It can’t hurt to have several canaries, each with their own unique sensitivities.