I would imagine that since you are reading this blog you are already familiar with VIX and the highly negative correlation it has to SPX, so I won’t expand on that any further. However you may not be as familiar with CDX which is a basket of Credit Default Swaps (CDSs). A CDS represents the credit component of a corporate bond which signifies the credit worthiness, or likelihood of a credit default occurring to a particular issuance. CDX is a basket of 125 single-name investment grade CDSs. CDX trades in credit spread terms between zero and 1000, i.e. 80, 81, 82, etc. The CDS spread increases as credit quality deteriorates implying greater risk of a credit default. Contrarily, CDS spreads narrow as credit worthiness improves which suggests a lower probability of default. CDX is currently traded over-the counter (OTC) and is used to insure or hedge bond portfolios against adverse price movements resulting from increased credit default risk.
Not surprisingly many of the same macro and micro-economic variables will affect credit (CDS and CDX) prices in the same manner as they would affect equity (Single-Name and SPX) prices. The only difference being that the price movements are inversely correlated, during a favorable economic environment SPX will increase while CDX will decrease. Since we already know that VIX is inversely correlated to SPX we can deduce that CDX and VIX are positively correlated, as shown below. Also noted below is that CDX and VIX reached their peaks at almost identical times in late ‘08. VIX traded to 80.86 on 11/20/08 while CDX traded to 275 on 12/5/08. SPX was a laggard hitting its lows at 676.53 on 3/9/09, three months later.
The chart below illistrates the price ratio, or relative value between CDX and VIX from ’07 to the present, during which time the average ratio was 4.67 to 1. On 8/28/08 the spread reached its peak at 7.35 (#1), demonstrating that CDX began its ascent much earlier and faster than VIX. Suprisingly it took VIX about one month of price appreciation before the relative value reverted back to the mean. Subsequently VIX continued its upward momentum for another two months which compresssed the levels back down to 2.70 (#2), on 10/15/08. Additionally, the 7.35 peak occurred over six months before SPX reached its trough which suggests that the CDX price behavior may perform as a leading indicator for both VIX and SPX. Currently the spread is trading at 6.68 (#3), just .67 pts. from it’s all time high of 7.35, potentially signifying another overextended situation.
So, if we believe in mean reversion, in this case 4.67 we can construe a couple of things. Either VIX is undervalued at 11.83 or CDX is overvalued at 79, their current levels (79/11.83 = 6.68). Keep in mind that VIX was trading at 11.98, .15pts. higher on 4/16/07 leading up to the credit crisis which prompted the stock market crash, makeing it difficult to argue the former. Furthermore do these extended levels indicate that SPX may be entering overbought territory? Hmmmmm…….Time will tell, but I suggest you keep these indicators (VIX and CDX) on your radar screen as you wouldn’t want what to miss what could be “the next big move”.