TED Spread: A (Pretty Good) Leading Indicator of the Stock Market?

Nov. 7.08 | 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 my last post, I looked at the TED spread as a lagging/concurrent indicator and showed that it’s been inconsistent at best. After that not-so-glowing review, I didn’t have high hopes for the TED as a leading/predictive indicator. But in this report I’ll show that, interpreted correctly, the TED has done a pretty good job at predicting monthly moves in the stock market.

2008110601
[logarithmically-scaled]

The blue line above shows the results of trading the S&P 500 (frictionless) was using the following strategy from 1988 to date: go long the S&P 500 following any month when the six-month exponential moving average (EMA) of the TED rose. The red line shows the inverse strategy (long when the EMA fell).

And, for the number-lovers:

2008110602

This is a contrarian strategy. Put simply, when recent TED readings are higher (indicating higher perceived interbank credit risk), we are buying the stock market. This is counterintuitive (i.e. we’re buying when things are getting worse), but as we’ve shown before, the stock market is usually darkest just before dawn.

Two additional comments:

  1. Note that October bucked the trend. The TED spiked very high in September, but the market most definitely did not rebound in October. We’ve seen this in just about all contrarian indicators, but over a long enough time horizon, I think we’ll find that this was the exception, not the rule.

  2. This strategy is very subject to curve fitting because I’m using monthly data and so few data points (n=250). But I would hedge that statement by saying this general principle worked using multiple approaches (not just EMA), multiple look back periods (not just six months), etc. so I think the concept is pretty robust.

Is the TED outstanding as a technical indicator? Definitely not. But it does have its purpose and will give us something to laugh at the next time the talking heads give an increasing TED as a reason to sell.

[Edit: click for a summary of all four TED spread related posts in this series]