Markets: What You Should Be Watching Now

What signals should investors pay attention to as financial markets gyrate? Here's what the pros are looking at

by David Bogoslaw

Big financial companies appear to be falling like dominoes as the credit crisis intensifies. In just the past two weeks, Fannie Mae (FNM) and Freddie Mac (FNM) were made wards of the state, Lehman Brothers (LEH) filed for bankruptcy, and Wall Street's signature brokerage, Merrill Lynch (MER), rushed into a hastily arranged marriage with Main Street mainstay Bank of America (BAC).

Market players have anticipated further asset writedowns and credit-rating downgrades for other big industry players by whacking their stock prices sharply lower.

Individual investors worried by all the turmoil may wonder what they should be watching as Wall Street quakes (BusinessWeek.com, 9/14/08). BusinessWeek offers five signals in the equity and credit markets that investors should keep an eye on to gauge whether the clanging chimes of doom are tolling louder for individual financial firms.

CREDIT DEFAULT SWAPS

The first barometer of market sentiment toward certain companies is what's happening with their credit default swaps, which protect the buyer by transferring the credit exposure of bonds from the purchaser to the seller. Prices for these instruments, which aren't regulated by the U.S. government, have spiked in recent weeks as the creditworthiness of certain financial firms has been severely damaged.

Credit default swaps on the widely followed Markit CDX North America Investment Grade Index jumped as much as 34 basis points to 229 basis points above the London interbank offered rate (LIBOR), an all-time high, at 11 a.m. on Sept. 16, according to Phoenix Partners Group, On Sept. 12, the index traded at 152 basis points above LIBOR.

Investors who want to check credit default swap spreads for individual companies can ask their brokers to look them up on a Bloomberg terminal or can find them in regular quotes in the financial press.

Investors also need to monitor the price and yields of new issues in the corporate bond market, says Bill Larkin, portfolio manager for fixed income at Cabot Money Management in Salem, Mass. On Sept. 16, the high-yield bond spreads over comparable Treasuries had widened to 9.05%, while the investment grade bond spreads widened to 3.80%—levels that haven't been seen in quite a while, he says. The higher yields signify lower prices on the notes, which means companies are paying more to raise capital.

For a general sense of where high-yield spreads are trading, investors can go to Yahoo Finance and look up the SPDR Lehman High-Yield Bond (JNK), an exchange-traded fund normally comprised of at least 80% of the total securities included in the benchmark Lehman Brothers High Yield Very Liquid index. They can also track the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), which generally invests in at least 90% of the securities in the iBoxx $ Liquid High Yield index.

Monitoring the bond prices of individual companies requires access to a broker's trading platform such as those provided by Charles Schwab (SCHW) or Fidelity Investments. "If you see a lot of the same issuance, be advised that may be another flag you need to research," says Larkin.

Uncertainty about the extent of the fallout from whatever happens to American International Group has caused more stagnation in the credit markets, with investors "hoarding cash right now and building up for the rainy day," he says.

OPTIONS VOLATILITY

Besides the credit market, activity in stock options can reveal a lot about the magnitude, if not the direction, of anticipated moves in stock prices.

A key number to keep an eye on is implied volatility, a forward-looking measure of expectations within the options market for impending stock moves.

The higher the implied volatility, the bigger the anticipated move in the stock price.

So how does an investor gauge whether the implied volatility of the front-month options contract is particularly elevated? The best way is to compare it with the 30-day historic volatility, which can be found on a number of options-related Web sites, including those of the International Securities Exchange, the Chicago Board Options Exchange, and the Options Industry Council, says Joe Cusick, senior market analyst at OptionsXpress (OXPS) in Chicago.

Each of these sites, as well as that of OptionsXpress, provides a toolbox that allows visitors to calculate the implied volatility for any given stock option.

In a sector under as much scrutiny as financials, implied volatility will be higher across all names in sympathy with the biggest losers, says Cusick. In that case, investors need to look for "remarkably higher" numbers, on the order of three or four times historic numbers, he adds.