Understanding The Credit Suisse Fear Barometer CSFB:IND

Understanding The Credit Suisse Fear Barometer CSFB:IND

Stock Markets have got to the stage now where it’s almost impossible to calculate in advance when or where a correction may begin. Unfortunately this makes them almost untradeable for me because I’m not comfortable entering swing long positions from such overbought conditions, whilst neither would I consider swing short’s without some form of confirmation.

Volumes are so abysmal and volatility so low that even day trading Indices is quite tough unless you’ve the patience of a Saint. In fact Friday’s NYSE and ES (e-mini S&P futures) volumes were the lowest of the year so far. This is the lowest non-holiday trading day on the NYSEVOL (from Bloomberg) since its data began a decade ago .

Reading Cobra’s blog I came across a mention of the CSFB Index which has just hit new record highs. Having no idea how this Index is calculated, I decided to find out.

Bloomberg writes:

“The CS Fear Barometer measures investor sentiment for 3-month investment horizons by pricing a zero-cost collar. The collar is implemented by the selling of a 10% OTM SPX call option and using the proceeds to buy an OTM put. The CSFB level represents how far out-of-the-money that SPX put is.”

Translated, this means the higher the level of CSFB, the higher the fear, or rather that investors are more willing to sacrifice potential upside gains on their investments by putting money into hedges as a way of protection instead of participating directly in further Market gains.

This chart from Bloomberg shows CSFB hit record highs this Week, with the previous record high just prior to the May 2011 Market Top, and the record high before that (not shown) was a couple of Months before the October 2007 Market top:

This Week’s record high in CSFB coincides with new record high’s in Bullish Sentiment and significant weakness in the VIX which is now itself showing divergence against the Stock Market trend.

With so many indicators available and many of them consistently appearing useless as predictive measures, can the CSFB really offer any clues into when Market’s are likely to correct?

Well, possibly it can, but not in the most obvious of ways. See, Market’s tend to top when everyone is bullish and few are bearish so Market tops often coincide with VIX printing continued lower lows, high levels of Bullish Sentiment and very little fear. But if this Credit Suisse Fear Index is making new record highs that would be counter-intuitive because it implies fear still exists to some degree.

Studying the chart in closer detail I noticed that the CSFB tended to top out slightly ahead of Market tops. This fits perfectly because it signals that markets top during periods when the most conservative investors have gained such a degree of confidence that even they begin reducing hedging exposure.

In conclusion and in addition to all of the common topping indicators we use, I believe that once the CSFB begins falling from a new all time high like the current one whilst markets continue to rise, we have a good indication that a Stock Market correction is imminent.

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