August 13th 2009

"...we'll be back this way again." Hank William Sr.


May 23 2008 was an important watershed date last year in addition to the September bankruptcy of Lehman Brothers. While the Lehman Brothers fall has been pretty highly documented, both at the time and in retrospect, May 23 had more stealth. The only reasonably widely followed fundamental indicator that we have found giving a signal of difficulty at the time was the TED spread beginning to widen more substantially. As you may have noticed in the last post, we included a brief description of what the TED spread is. Today we will expand that definition in order to illustrate why it may have been an indicator of termoil in the bank credit world at that time.

It is stated that the TED spread supposedly measures credit difficulties arising in the international banking systems the differential between rates charged by LIBOR member banks for a given time frame increases relative to the US Treasury rates for the same time frame as expressed by the relevant futures. In other words, if international banks feel a need to charge more for loans they make relative to the US Treasury rate for the same maturity; it is assumed that they are doing so because of a rise in perceived risk in the economy. One such rise in the TED spread began around May 23, 2008.

We use turning points from the Economic Confidence Model (popularized by Princeton Economics Institute) as one of our guidelines for finding points in time that may bring interesting activity in the markets. That model had turned down around February 25, 2007; conveniently the TED spread does not move in straight lines. We are speaking more of significant changes in the near-term trend.

Continuing the trend noted above, the TED spread began to narrow around the next upturn in the model, roughly March 23, 2008. Two months later (May 23, 2008) without an observable change in direction by the model, the TED spread began to widen again more considerably. In fact, by mid-October, 2008 the spread had widened to a five year high. From that point to February, 2009, there was a general decline in the spread, followed by a short move wider into March 9, 2009. Since then the general trend has been narrower up to the present date.

It seems reasonable to attempt to correlate the moves of the TED spread with those of the stock market. It is our opinion that the TED spread has some coincident negative correlation with the stock market in recent years. That is a widening TED spread seems to indicate a falling market, and vice versa. We do not mean to imply a direct cause and effect relationship, rather that they both may share sensitivity to the same outside forces. Either way, a significant widening of the spread should probably serve as an alert to stock investors. We follow it regularly now.

At times like this when some measures might imply that some of the stock indices are somewhat overbought, we tend to pay even more attention to indicators that may not be directly equity related, but have shown effects on equities. We also pay more attention to weekly charts of both indices and individual stocks. It is important to make use of all sources when considering making decisions. We also use stochastics and Bollinger bands as additional aids along Ibbotson data and data provided by other sources when it comes to tactical asset allocation decisions.