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Elran
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I am a senior electrical engineer and inventor ,my job is to find insightful solutions to address technology related needs. I started investing 12 years ago, and it is a hobby i take very seriously.I use my technical and academic skills to engineer consistent and reliable strategies aiming to... More
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  • Market TIming Using TED Spread 5 comments
    Nov 14, 2013 10:39 AM

    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&P500

    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 results

    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 strategy

    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.

    Follow us for more strategies involving Tactical asset allocation.

    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.

    Themes: market-outlook
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Comments (5)
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  • Janet86
    , contributor
    Comments (2) | Send Message
     
    great share..
    very informative!
    17 Nov 2013, 12:05 PM Reply Like
  • AAinPB
    , contributor
    Comments (2) | Send Message
     
    Sorry to be slow, but what do you mean by the spread <1.5:

     

    LIBOR divided by T-Bill <1.5?

     

    The current figures are LIBOR =0.24 and T-Bills =0.06 for a ratio of about 4.0 and a delta of about 18bps.

     

    Help! Thanks very much.
    1 Dec 2013, 01:47 PM Reply Like
  • Elran
    , contributor
    Comments (62) | Send Message
     
    Author’s reply » Ted spread =LIBOR minus T-Bil < 1.5
    Using your data the current Ted spread is 0.18 , indicating rather low credit risk as perceived by banks.
    1 Dec 2013, 04:52 PM Reply Like
  • AAinPB
    , contributor
    Comments (2) | Send Message
     
    Thank you! I guess I shouldn't be so skeptical when it seems too simple/too good!
    1 Dec 2013, 10:20 PM Reply Like
  • Elran
    , contributor
    Comments (62) | Send Message
     
    Author’s reply » I always prefer simple strategies as long as they have a sound logic behind it - the logic behind this system is that you get in the market when fear is rising but not at extreme levels.
    2 Dec 2013, 05:47 AM Reply Like
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