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 :
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 :
The strategy spent 45.8% of the time invested in the market yielding return of 12.13% (not including dividends).
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 :
The improved strategy spent 44% of the time invested in the market yielding return of 16.3% (not including dividends).
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.