With CDS correlations the upshot is all downside for equities

If you’re feeling uneasy about the relatively benign progress of European stock indices since Q3 2011’s turbulence, you might be wondering when the next shock will hit the equity markets. Take a look at credit default swaps and you may find a curious relationship that could help you anticipate sharp falls.

I don’t think it’s too disingenuous to say when equities markets begin to soar, money managers can sometimes be guilty of divorcing themselves from reality and jumping in with both feet. But credit guys don’t. As professional risk pricers, when they believe their models are a little over-optimistic, they override them. If a bull run looks overstated, fixed income traders may refuse to follow the market up, based on strong convictions about how the risk should be priced. This is a good reason to believe credit default swaps (CDSs) can help you anticipate a nasty downside.

Compared to bonds and other fixed-income instruments, CDSs are often seen as a more pure credit risk instrument, as they are relatively free of guarantees, covenants, embedded options and coupons, and Chris Parkinson at inter-dealer broker GFI’s Christopher Street Capital has been closely following their correlations with equity markets. His years of analysis provide a pretty convincing argument that while CDS and equity relationships tend to be inverse, when this relationship breaks down, you often see subsequent changes in direction in the equity markets.

Parkinson isn’t saying credit markets persistently lead equity markets – in fact, his data suggests the opposite. Most of the time equities tend to lead credit. But if CDS spreads look like traders are overriding traditional risk pricing models and basically ignoring equity valuations, then your equity portfolio could be in for a bumpy ride in the not-too-distant future. Parkinson has found that when CDS spreads ignore equity valuation inputs, the equity is twice as likely to correct itself to reflect the credit market’s view than the other way around.

Case in point: If you had tracked the 90-day correlation between the Stoxx 600 versus the iTraxx CDS index, you would’ve seen a giant decline in the correlation well ahead of the Lehman Brothers’ collapse. Last February, there was another great disconnect during an equity bull market, where credit valuations were already saying equities were overpriced a sovereign debt trouble was brewing. Over the course of 2011, this indicator rang true, with equity markets severely down at year-end.

CDSs tell you quite clearly what bond markets are thinking. And while equities price reward, credit markets price risk, making CDSs particularly relevant now, when the equity markets are more-than-usually focused on risk. But equities desks are only just getting used to the idea of looking at the credit markets to gauge how a stock or index might perform. Until now, the most common use of CDS data by equities desks has been to make sure their counterparties weren’t about to go bust. In an increasingly correlated market environment, equity desks may need to take a multi-asset market view more frequently – even for more singular mandates.

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