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.
