TED Spread: A Lagging Stock Market Indicator

Nov. 6.08 | About: SPDR S&P (SPY)

[This week I’m focusing on the TED spread and what it can tell us about the stock market. If you're not familiar with the TED spread, you can read more about it here.]

In this report, I’ll look at the TED spread as a lagging indicator (or more accurately, a concurrent indicator) of the stock market. In a nutshell, I want to know what the stock market is doing when the TED spread is rising vs falling and high vs low. There are a lot of observations in this report so I’ll summarize at the end.

A reminder of where we’re at today. Below is the TED (through October 22). We are at historic highs, but a bit off of the all-time peak reached on October 10.

20081103062

Rising vs. Falling TED:

The graph below represents trading the S&P 500 in months when the TED had risen (blue) or fallen (red) since 1987.

2008110307
[logarithmically-scaled]

At first blush, it looks like the market fares poorly in months when the TED increases. This is intuitive - an increase in TED should in general be bad. Looking at the same graph since 1995 however, paints another picture. See graph below.

20081103081
[logarithmically-scaled]

Since 1995, monthly changes in the TED and the market have had no connection. The market has performed about the same regardless of the direction of the TED.

Looking at daily changes (rather than monthly), paints yet another picture. The following graph represents trading the S&P 500 on days when the TED rose (blue) or fell (red):

20081103091
[logarithmically-scaled]

At this daily level, the TED vs, stock market relationship has been inconsistent; at times both rose together, at times they moved against each other, and at times, they didn’t seem to have any relationship at all. At this moment, on a day-to-day basis, the S&P 500 tends to fall when the TED increases (and vice-versa).

High vs. Low TED:

I divided historical monthly TED ratings into quintiles based on how high or low they were compared to the previous five years. The following graph shows trading the S&P 500 during the months when the TED was in each of these quintiles:

20081103102
[logarithmically-scaled]

The results are inconclusive. The market has on average performed poorly when TED spreads were very low (this is counterintuitive), but most of those losses came during a single period - the bear market of the early 2000’s.  Our current bear market came during very high TED readings during which, prior to the start of this bear, we experienced the very best returns. Again, high/low TED readings are inconsistent and I think inconclusive.

Summary of Observations:

As a lagging or concurrent indicator I think we can say that:

  • Prior to 1995, the market tended to perform poorly in months when the TED increased (this is intuitive). After 1995, that relationship disappeared, but might be rearing its head again during the current credit crises.

  • The daily relationship between the TED and the market has been inconsistent. At times, they’ve been positively related, while at other times, they’ve been negatively related. At the moment, the TED tends to fall when the S&P 500 increases (this is intuitive).

  • High or low TED spreads haven’t consistently told us anything about the stock market. On average, a low spread has been bearish (this is counterintuitive), but that’s solely the result of low spreads during the bear market of the early 2000’s.