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Market TIming Using TED Spread

The TED Spread measures the difference between the three-month LIBOR (interbank loans rate) and the three-month T-bill interest rate, it is a commonly used indicator of perceived credit risk. An elevated TED spread readings is a sign that lenders believe the risk of default on interbank loans is high and therefore, demand a higher rate of interest relative to T-bills (which are considered risk free).

So does the TED spread give us any clue on future performance of the stock market?

Look at this graph :

(click to enlarge)TED spread Vs S&P500Click to enlarge

In the above graph we can see that before and during bear markets (1987,2000-2002,2008) TED spread tend to be high. Looking more closely we can identify that there is a positive short term correlation between TED spread and S&P500, Meaning that rising TED spread tend to lead to better stock market performance.

We can take advantage of this positive leading correlation by using a very simple market timing strategy: In the last day of every month calculate the TED spread if the spread increased during the month, buy the S&P on the next opening and hold it for one month, if the spread decreased during the month, sell the S&P on the next opening and hold cash one month.

I backtested this strategy from 1987 until 2013 see the graph below :

(click to enlarge)Ted spread market timing strategy - backtest resultsClick to enlarge

The strategy spent 45.8% of the time invested in the market yielding return of 12.13% (not including dividends).

The CAGR=12.13*45.8%=5.56%.

Max drawdown was -28.44%

Sharp ratio =0.44

Being in the market in the rest (56%) of time when the last month TED spread decreasing would have resulted with yield of 3.67% and Max draw down of -60%.

We can even make this strategy much better by adding another rule to the existing strategy :buy only if TED spread is <1.5, This will prevent us from jumping into the market during very high credit risk periods which usually means bear market conditions for the S&P500.

Look at the results of the improved strategy :

(click to enlarge)TED spread improved strategyClick to enlarge

The improved strategy spent 44% of the time invested in the market yielding return of 16.3% (not including dividends).

The CAGR=16.3*44%=7.17%.

Max drawdown was -24.66%

Sharp ratio =0.8

We can see that the TED spread does a good job as a leading market indicator, so it worth following.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.