At 8:30 on Friday morning the big news was the 49,000 job losses for the month of May. That headline lasted about an hour before oil grabbed the headlines in a steel grip that lasted all day. I will get to the reasons later but the key metric was the +$10.75 rise for the day to close at $138.50. This was the biggest price move in the history of the Nymex and the biggest percentage move since Iraq invaded Kuwait. The rest as they say is history as the explosion in oil greased the general market decline.
Wilshire Total Market Index Chart - Daily
Before I get to the oil story I need to touch on the economics. The biggest economic report on Friday was the Non-Farm Payrolls for May. The report showed the economy lost 49,000 jobs, which was actually less than the -60,000 loss analysts expected. The component that grabbed the headline was the spike in unemployment to 5.5%. The +0.5% spike in unemployment was the biggest single month jump in 22 years. The loss of jobs has now stretched for five consecutive months. However, the losses are minor compared to prior recessions. At the same point in prior cycles we were seeing 150,000 to 250,000 job losses per month. The current average decline for this cycle has only been -65,000 jobs. This has been a very tame economic slowdown.
The Jobs report captured the headlines with the 22-year spike in unemployment but that was an accounting anomaly rather than a real number to worry about. There was a shift into May by a large number of teenagers and college students looking for summer jobs. The youth employment market is being the hardest hit by the rise in prices and cost cutting by employers trying to trim expenses. The majority of teenage jobs are in fast food and restaurants and those are exactly the retail outlets suffering the most by high gasoline prices. An obscure factoid I heard was teenage unemployment at a 60 year high. There was a one-week shift in the accounting period and that also skewed the numbers.
May Non-Farm Payrolls
The economics for next week will be highlighted by the Fed's Beige Book on Wednesday and the Consumer Price Index on Friday. The Beige book will tell us how the various Fed regions are doing in this economic slowdown. Do they see the economic activity in their region slowing or rebounding? This is always a volatile event.
The biggest report for the week will be the Consumer Price Index. How much of the higher oil price has filtered through into consumer products? I can't conceive that oil prices have not influenced consumer prices. The Fed takes out direct food and energy prices as too volatile to track monthly but the indirect costs for transportation and raw materials has got to be pushing inflation higher. The Fed is facing the worst of all scenarios. Oil prices are out of control. The tax rebate stimulus has been consumed by the increase in the price of gasoline. Unemployment is rising at least on the surface and the economy is bordering on a recession. This is the return of stagflation in its purest form. No growth and soaring inflation. The Fed has to raise rates if the CPI shows an inflation spike but raising rates will slow the economy even further. They can't move in either direction on rates without escalating either inflation or recession. Their best move would probably be to cover their eyes and ears and do nothing in hopes the economic situation recovers on its own. James Bullard, President of the St. Louis Fed, basically agreed with that plan saying the Fed could remain neutral for the rest of the year. However, he also said the dominant policy concern was rapidly changing from the credit crisis to pressing inflationary concerns. The next Fed meeting is June 24th.
Now to the real market story. Oil prices declined to $121.61 on Wednesday night and then rebounded to $128 on Thursday. The net gain was a record $5.50 on Thursday. That was the largest single day dollar gain on record. It was nothing compared to Friday. On Friday crude prices added to that Thursday spike with another gain of $10.75 to close at $138.50 and another record high and the largest single day price gain in the history of the Nymex. It was the second largest percentage gain since Iraq invaded Kuwait in 1991.
The reasons for the spike were numerous. You hear people, including me, using the perfect storm analogy all the time but this was the perfect example. For purposes of clarity I will try to list all the reasons.
First there was a serious drop in open interest of roughly 50% as the lawmakers and the CFTC were discussing futures trading and energy market manipulation. Short interest rose significantly in anticipation of some sweeping change that could crater the energy market. When both parties made some calming comments on Wed/Thr that suggested it would be a couple months before any changes were made the bulls jumped back into the market and a monster short squeeze began on Thursday with the $5.50 gain. Volume was still low as though traders were still not convinced.
On Friday the market opened with the shorts worst nightmare. Morgan Stanley said the stage was set for $150 oil before July 4th because of supply constraints and increased global demand. July 4th is only 27 days away and $28 from the Wednesday lows. That gave new urgency for longs to reenter the market and for shorts to cover.
At the same time Shaul Mofaz, former chief of staff and defense minister in Israel said an Israeli attack on Iran would be unavoidable if they did not immediately halt their nuclear program. "If Iran continues its nuclear arms program we will attack it." Iran's President Mahmoud Ahmadinejad has more than once called for the elimination of Israel. Mofaz said Ahmadinejad would disappear before Israel does. Iran is the 4th or 5th largest oil exporter depending on whose numbers you believe. If Israel did attack their nuclear facilities it should have no impact on oil production but you never know. They could cripple their oil capability at the same time just for spite. There is precedent for an Israeli attack. In 1981 Israel planes destroyed an unfinished reactor in Iraq to prevent Iraq from gaining nuclear weapons. They struck another reactor under construction in Syria several months ago. Reportedly the U.S. has already approved an Israeli attack but I strongly doubt it. Regardless this was a comment that oil traders could not ignore. 25% of the world's oil goes through the Straits of Hormuz and Iran could block that passage to cripple the west for supporting Israel in an attack. Venezuela has also threatened to halt oil shipments to the U.S. if Iran is attacked.
At the same time Obama vowed to eliminate the threat posed by Iran to world security. "The danger from Iran is grave and real and my goal will be to eliminate this threat." He also said he would do everything possible to prevent Iran from obtaining a nuclear weapon. It appears the potential next president of the U.S. is already positioning himself to attack Iran. That gave oil traders one more excuse to buy oil.
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Also pushing oil higher was a limit up move on heating oil. Heating oil is seen as a proxy for diesel since both are products of the distillate process. A barrel of crude produces an average of 9.21 gallons of diesel, 1.75 gal of heating oil and 1.76 gal of fuel oil from the distillate process. There are also 19.15 gallons of gasoline and 3.82 gal of jet fuel. Depending on demand for a particular product additional refining steps can be taken to increase the percentage of a specific product. Demand on diesel is growing sharply and that puts pressure on the other distillates like heating oil. Trading heating oil therefore is a proxy for diesel. A limit up in heating oil puts pressure on all the crude products.
Also fueling the spike was the third consecutive weekly drop in crude inventories. This week's drop was -4.8 million barrels and that brings the total three week decline to -19 million barrels. If there is so much oil in the world then where is it? Current U.S. crude inventories are 11% below 2007 levels.
The weekly EIA report showed that over the last four weeks total crude consumption had fallen only 1.1% compared to the 3%-4% numbers being reported in the retail surveys. Gasoline demand had only declined -1.4% nationwide compared to the MasterCard Spending Pulse report showing a -4.7% drop for the week. This EIA demand picture was much more bullish since it was significantly less of a drop and suggested consumers were getting over the high prices and continuing life as normal.
The better than expected jobs report also boosted demand estimates since a stable job market contributes to stable consumption of crude products. Since many economists believe the economy has passed the bottom and is beginning to recover that jobs report was bullish for demand estimates.
Finally the war of words over rates between the ECB and the Fed effectively killed the rally in the dollar over the last two weeks. The last two days were extremely ugly after ECB President Jean-Claude Trichet said the ECB was considering raising rates as early as next month to fight inflation. Since the Fed is going to be challenged by recent economic events to raise rates that meant the dollar lost ground against the Euro. The two-day plunge on the chart below was just an added factor for the rise in crude.
USD Index Chart
Those events above contributed to the perfect storm for crude prices. Shorts were squeezed even harder by the lack of volume and the bulls kept buying everything in sight. There was a school of thought that shorting Thursday's close at $128 was the right thing to do technically. When that did not work they were forced to cover and that made the prior high at $135 the next obvious short. For four hours that $135 short resistance held on Friday but as the close approached with a volatile weekend ahead the bears were forced to cover and the last hour of trading saw another $4.50 gain. This spike should translate into another 10-15 cents per gallon at the pump by Wednesday of next week. It could be even more for diesel. AAA said the national average for gasoline was $3.99 on Wednesday making a jump over $4 next week almost certain.
The $150 price target by Morgan Stanley and several other firms is looking like a self-fulfilling prophecy today. With the close at $138.50 that is only $11.50 away. According to NOAA there is a tropical wave building in the Atlantic that has the potential to turn into a storm as it moves into the southeastern Caribbean. If this turns into a storm by Monday we will be looking at additional pressure for prices to move higher. Goldman's short-term target of $141 was ridiculed when they made it two months ago. Friday's high of $139.12 was close enough for them to claim a win. Boone Pickens said $150 by November. Stepping out a little farther there are predictions of $200-$225 in 12-18 months and $250-$500 in 36 months.
Remember my crude oil chart from last Sunday? I have reprinted it here for review. Note the comment on the chart. Wednesday's close was $122.30. I did not expect the move we got but those who followed my suggestion did well.
Last Week's Crude Chart
This Week's Crude Chart
The two-day $15 spike in oil prices crushed the transports, which closed at a new historic high on Thursday at 5493. For the life of me I can't understand why the transports were doing so well when the airline sector is tanking so hard. Continental joined the diet club and said it would ground 67 planes, cut jobs and reduce capacity due to oil prices. So far in the last 90 days the U.S. airline sector has seen over 500 planes either taken out of service or plans announced to ground them. Over 14,000 jobs have been cut and existing capacity has been reduced by 15%. They will save a lot of money with those changes but with oil prices rising so fast they are still losing ground. One analyst said the gains in oil prices over the last two days alone have increased the fuel bill for U.S. airlines by $4 billion. They were already projected to have moved from year-end 2007 expectations of a $4 billion profit in 2008 to a $2.3 billion loss if fuel stayed around $110 for the rest of the year. At $130 that loss was expected to grow to $6.1 billion and at Friday's close at $138.50 that loss was expected to grow to $10 billion for the year. You can't continue to lose that kind of money and stay in business. Analysts claim the airlines will have to raise prices by 25% to 35% just to break even. With the airlines in the tank and UPS and FDX bleeding profits from higher fuel costs, where is the strength in transports? Railroads of course. They are the winners in any continued high oil scenario but even they crumbled on Friday.
Ironically even the oil stocks lost ground on Friday. Refiners were sold hard as crack spreads disappeared at $138. Valero lost -3.31. Exxon with the largest reserves of any public company lost -$2.52. Even the drillers, the companies expected to benefit most by increased exploration, were knocked off their rigs. Transocean lost $4 to cap a $20 drop over the last three weeks.
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Can anybody say tough market? Nothing is working more than a day or two and the markets are becoming increasingly volatile. When energy companies can't even rally on a $15 spike in oil then no company is safe. The indexes remain strongly diverged with the Russell and Nasdaq still holding the high ground while the Dow and S&P have both broken strong support. To illustrate the divergence the Russell only lost -8 points for the week while the Dow lost -428.
The Dow and S&P are falling on the continued decline in financials. The brokers are expected to report in two weeks but rumors of an earlier release by Lehman are circulating. Their official release date is June 16th but they are currently trying to attract additional capital. To do this they may need to release earnings earlier in order to put investors at ease. The shorts are punishing Lehman and volume has been huge. There are worries that Lehman could turn into another Bear Stearns because they can't deleverage fast enough. An early earnings release that was better than expected could do wonders for investor confidence.
The Dow lost -394 points on Friday to close at 12209. This is below several levels of recent support and appears to be targeting the March lows of 11750. Granted this is due mostly to the implosion in the financial sector with AIG under pressure again on Friday. Boeing was also a major decliner as traders flee the stock on worries airlines are going to cancel orders. Once the brokers report earnings in two weeks the Dow could recover. However, I believe sentiment may have been damaged significantly by this week's results. The +209 gain on Thursday was attributed to an asset allocation program where treasuries were sold and market indexes were bought. Many retail investors jumped on for the ride and were rewarded with Friday's -400 point loss. Frustration is setting in as traders start contemplating summer vacations, barbecues and yard work rather than fight the markets. I had more than one trader email me in the last couple of weeks expressing their frustration with the market. It is called summer and the opposite of our current extreme volatility is the approaching summer doldrums where nothing happens. It makes you appreciate the "sell in May" strategy.
Dow Chart - Daily
The S&P mirrors the Dow for the reasons I listed above and Friday's close at 1360 was a loss of -43 points. Critical support at 1370 was broken and critical resistance at 1405 has now held twice in the last two weeks. Both the Dow and S&P have clear chart failures and are projecting drops to lower levels. These are not charts I would buy.
The Nasdaq is struggling to hold on to its recent gains and Friday's -75 point beating knocked it back to 2475. Over 2440 the trend is still intact but the Nasdaq is not going to survive a continued swoon by the Dow and S&P. The chip sector is still strong with support on the SOX at 400. Intel was a drag on Friday after South Korea fined them $25 million for antitrust claims. I am neutral on the Nasdaq over 2440, bearish below that level. I would be bullish over Thursday's high at 2550. Cisco hit a five-month high on Thursday so tech is still alive but having a tough time carrying the Dow on its back.
Nasdaq Composite Chart - Daily
The strongest chart is still the Russell 2000 and I am confused as to why. The Russell should not be leading the pack given the weakness in the Dow and S&P. I have been bullish over 730 and it closed at 740 on Friday. I thought we were good to go after the 762 breakout and close on Thursday. Obviously I was very depressed to see the decline on Friday despite it being better than the other indexes. You can still lose money on a falling leader. I am turning neutral on the market in general but I will continue to have a slightly bullish bias over 730 on the Russell. Under 730 I would be short or flat.
Crude prices should remain volatile and that is actually a negative. Many traders are walking away from trading crude because of the volatility. This reduces liquidity and actually makes it even more volatile. Expect some more big moves but they should all be news related.
The biggest stock even for next week is the Apple announcement on Monday. Steve Jobs is expected to announce the 3G iPhone at 10:00 and the market for Apple stock should be extremely volatile around the announcement. Many think the news is already priced into the stock while others think Jobs will pull another rabbit out of his hat with some astounding features. Some feel the iPhone novelty is wearing off and there are no big features other than the 3G capability. One analyst pointed out that adding the 3G feature added nearly 700 million potential customers in Europe and Asia. Those customers were prevented from buying a regular iPhone because no network in their area supported it. This should give Apple a significant new audience.
I would be cautious about entering new positions next week. This is a traders market and not a scenario for buy and hold investors. There is no need for an investor to be in the market at all times. Wait for a key inflection point and use smaller positions until a trend develops again. Lost opportunity is better than lost capital.
Play Editor's Note: After Friday's big sell-off I'm expecting an oversold bounce but would use it as an opportunity to open new bearish positions. FYI: A couple of more stocks we think look like bearish candidates are JEC and TXT.
Caterpillar - CAT - close: 79.99 change: -2.74 stop: 84.05
Why We Like It:
BUY PUT JUL 85.00 CAT-SQ open interest=4781 current ask $6.45
Picked on June xx at $ xx.xx <-- see TRIGGER
DaVita Inc. - DVA - close: 50.42 chg: -1.37 stop: 53.01
Why We Like It:
BUY PUT JUL 55.00 DVA-SK open interest= 857 current ask $4.90
Picked on June xx at $ xx.xx <-- see TRIGGER
Terex Corp. - TEX - close: 67.37 change: -3.56 stop: 72.05
Why We Like It:
BUY PUT JUL 70.00 TEX-SN open interest= 731 current ask $5.50
Picked on June xx at $ xx.xx <-- see TRIGGER
Peabody Energy - BTU - close: 77.74 change: +0.74 stop: 73.92*new*
BTU shot past our first target again. The stock gapped open at $78.27 and surged to $80.90 before eventually succumbing to market weakness. Our first target was the $79.75-80.00 zone. Friday's trading marks the fourth failed rally in four weeks under $81.00. The general trend is still higher but short-term this failed rally is bearish and is suggesting a dip on Monday. BTU has found some support near its 21-dma region so look for a pull back to $75.00-74.50. We are not suggesting new positions at this time. Our second, more aggressive target is the $84.00-85.00 zone. Please note that we're moving the stop loss to $73.92.
Picked on June 01 at $ 73.92 /1st target exceeded 79.75
iShares Russ.2000 - IWM - cls: 73.92 chg: -2.28 stop: 72.95
Ouch! Friday's 3% reversal lower in the IWM completely erased Thursday's gains. The small cap ETF is back under resistance at the $75 level (750 for the RUT) and volume was huge on the reversal. Stepping back the trend in the Russell 2000 small cap index (and the IWM) is still bullish. However, if the DJIA and the S&P 500 keep falling we would expect the RUT to follow. We're not suggesting new positions at this time and after Friday's big drop we would seriously consider an early exit and jump ship. We had a conservative target in the $74.50-75.00 zone but we've been aiming for the $77.00-80.00 range.
Picked on April 28 at $ 72.55 *triggered
Priceline.com - PCLN - close: 132.48 chg: -4.86 stop: 129.90
PCLN erased all of our unrealized gains with a 3.5% drop on Friday. The stock fell to $130.64 on Friday afternoon before bouncing. Odds of an oversold bounce after Friday's big market sell-off are pretty good. We would consider new positions here. However, before you initiate new positions double check just how much risk you are willing to take. This is not a great market for starting new bullish trades. Thus far the Russell 2000 and NASDAQ have been able to maintain their bullish trend in spite of the reversals in the DJIA and S&P 500. If the S&P 500 continues to fall we would expect the NASDAQ to break down and then the tech sector could play "catch up' with the S&P 500. PCLN could plunge toward support near $120. Right now PCLN should have short-term support at $130 so we're leaving our stop at $129.90. We've been targeting the $139.50-140.00 zone.
FYI: Nimble traders may want to already start plotting bearish strategies if PCLN breaks down under its 50-dma or the $127.50 area. We would expect some support at its 100-dma near $120.
Picked on May 27 at $132.75 *triggered
Molson-Coors Brewing - TAP - cls: 58.07 chg: -1.19 stop: 56.45*new*
It's probably splitting hairs but TAP's 2% loss on Friday might be considered relative strength against the 3% drop in the S&P 500. The trend is still up but we would hesitate to open new bullish plays at this time. We are going to try and reduce our risk by raising the stop loss to $56.45. Our target is the $64.00-65.00 range. FYI: The P&F chart is bullish with a $69 target.
Picked on May 23 at $ 58.51 *triggered
Emerging Markets 50 ADR - ADRE - cls: 54.07 chg: -1.72 stop: 56.85
The market weakness reversed yesterday's gains in ADRE. This is a failed rally at its short-term trendline of resistance and a new entry point to buy puts although we should probably expect a bit of a bounce on Monday. We are adjusting our stop loss to $56.05. We are aiming for the $51.00-50.00 zone. FYI: The P&F chart is still bullish.
BUY PUT JUL 55.00 QDF-SC open interest= 10 current ask $3.00
Picked on June 03 at $ 54.69
Electronic Arts - ERTS - close: 47.55 chg: -1.99 stop: 49.75*new*
The widespread weakness fueled a 4% decline in ERTS and the stock broke down from its three-week trading range. The drop under support at $48.00 is good news for the bears. We were suggesting a trigger to buy puts at $47.75 so the play is now open. If you are looking for a new entry then consider waiting for a bounce back toward $48.00, which should now be short-term resistance. Our target is the February lows near $44.50-44.00. We're adjusting the stop loss to $49.75, which is just above the Thursday high.
FYI: There is an ongoing story here with ERTS and its attempt to buy rival TakeTwo Interactive (TTWO). Late last week TTWO said they were in (serious) talks with another suitor. Releasing this news may have been an attempt to get ERTS to up its stake for TTWO. If ERTS does raise its bid the stock will probably continue lower as investors worry about overpaying for TTWO.
BUY PUT JUL 50.00 EZQ-SJ open interest=4349 current ask $3.70
Picked on June 06 at $ 47.75 *triggered
3M Co. - MMM - close: 74.86 chg: -2.64 stop: 77.65 *new*
A 400-point drop in the DJIA inspires a lot of momentum and Dow-component MMM gave in with a 3.4% decline. The stock finally broke support near $75.00 and hit our suggested trigger to buy puts at $74.95. The play is now open. We have two targets. Our first target is the $70.25-70.00 zone. Our secondary target is the $67.00-65.00 range. The P&F chart is bearish with a $69 target. Please note we're adjusting our stop loss to $77.65, which is just a few cents above Thursday's high. After such a big downdraft on Friday a bounce back to $75.00 or $75.50 could be used as a new entry point for puts. FYI: If you are aiming for the $67 target then you might want to consider the October puts.
BUY PUT JUL 80.00 MMM-SP open interest=3996 current ask $5.70
Picked on June 06 at $ 74.95 *triggered
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
Amgen Inc. - AMGN - close: 44.24 chg: -0.69 stop: n/a
After nearly two weeks of gains AMGN held up pretty well on Friday with a 1.5% loss versus the S&P 500's 3% loss. Even though the stock is showing relative strength if you have the June options you may want to consider an early exit to just cut your losses. We only have two weeks left for June strikes before they expire and the erosion is going to pick up speed. We are not suggesting new positions at this time. We have suggested a July strangle and a more aggressive June strangle. The options in the July strangle are the July $45 calls (AMQ-GI) and the July $40 puts (AMQ-SH). Our estimated cost for the July strangle was $1.65. We want to sell if either option hits $3.50. The options in the June strangle are the June $45.00 calls (AMQ-FI) and the June $40.00 puts (AMQ-RH). Our estimated cost on the June strangle was $0.56. We want to sell if either option hits $1.10 or more.
Picked on May 22 at $ 42.77
McDonald's - MCD - close: 56.95 chg: -1.10 stop: n/a
Shares of MCD continue to sour. The stock lost 1.89% on Friday, which was better than the market averages, but the stock was already in a downtrend. It looks like MCD could tag technical support at its 200-dma near $56.45 soon. Traders may want to exit near $56.50 even if the June puts fail to hit our target at $1.65. The June $57.50 puts hit an intraday high of $1.30 and are currently trading at $1.25bid/$1.35 ask. We are not suggesting new positions. The options we suggested were the June $62.50 calls (MCD-FZ) and the June $57.50 puts (MCD-RY). Our estimated cost was $1.10. We want to sell if either option hits $1.65 or higher. Keep in mind that June options expire in two weeks and will see their premium erode more quickly.
Picked on May 18 at $ 60.53
Tyco Intl. - TYC - close: 44.01 change: -1.25 stop: n/a
Hmm.... we find it interesting that as the DJIA and the S&P 500 were accelerating their losses into the closing bell on Friday shares of TYC were not. The stock dropped early Friday morning and then traded sideways near its exponential 200-dma. We are not suggesting new strangle positions in TYC at this time. The options we suggested were the July $47.50 calls (TYC-GW) and the July $42.50 puts (TYC-SV). Our estimated cost was $1.30. We want to sell if either option hits $1.95 (50% gain).
Picked on June 03 at $ 44.89
Valero Energy - VLO - close: 46.33 change: -3.31 stop: 47.99
Wow! On Thursday night I decided to stick my neck out on the refiners as they bounced from what should have been support. Rising crude oil prices just cut my head clean off. Thursday's $5 jump in oil was a record-breaking move. No one thought that it would be crushed by a $10 gain the very next day. Rising oil pushes the crack spread lower and refiners make less money. VLO just plunged right through support and quickly hit our stop at $47.99.
Picked on June 05 at $ 49.64 /stopped out $47.99
Nearly every day, a financial channel or news services pronounces the credit crunch behind us. Not so fast, others say. In his May 27 letter to fund investors, John P. Hussman, Ph.D. (www.hussmanfunds.com) warned that "credit default swaps blew out last week in a manner that we haven't seen since the week before the Bear Stearns debacle."
The TED Spread may help us determine when the crunch has eased or whether we need to start burying jars of money in our back yards. The simplest definition of the TED spread is that it's the difference in yield between U.S. treasuries and InterBank loan rates, the rates at which the major banks loan money to each other. Originally the calculation involved the spread between the yield (or futures' price, according to some sources) on a three-month U.S. treasury bill contract, from which the "T" was derived and that on a three-month Eurodollars contract, from which the "ED" was derived. Each had identical expiration rates, and the Eurodollars contract was that represented by the London InterBank Offered Rate (LIBOR).
What was being measured? Stated simply: risk. In TECHNICAL ANALYSIS EXPLAINED, Martin J. Pring says the TED spread "measures the relationship between ("high"-quality) T-bills and ("low"-quality) Eurodollars." Most consider the U.S. treasuries as close to risk free as investors can get. The rate for the Eurodollars futures contract, used in the original computation of the TED spread, is impacted by the perceived credit risk of lending to commercial banks.
If the spread between the two rates is relatively tight, the risk of default is believed to be decreasing. If the spread widens, the risk of default is believed to be increasing. If investors fear that risk is increasing, they'll start buying the safer U.S. treasuries, sending rates lower and widening the spread, especially if investors are concurrently shunning riskier corporate borrowers.
These days, the computation has been reformulated. When the Chicago Mercantile Exchange stopped offering futures on the T-bills, the TED spread was recalculated using the spread between the interest rate for three-month T-bills and the three-month LIBOR. The spread is calculated in basis points. Thus, if there's a 0.2 percent difference in the rates, the TED spread is 20 basis points or 20bps.
Some believe that a normal TED spread would likely be in the 10-50 basis points range. Last year it ballooned up to 250 basis points at one time, indicating that the risk of default was high. Since August 9, 2007, when it closed at 0.72 or 72 basis points, it has stayed consistently above those normal levels. The low since August 9, 2007 was recently achieved on May 27, when the TED spread closed at 0.7553 or 75.53 basis points.
In an August 29 article, "Understanding the TED Spread," Bespoke Investment Group warned that of mixed SPX performances after extreme TED Spread readings. For example, that article noted a spike on April 21, 1987 that resulted in lower values for the SPX a week and month later, but higher levels in three months. The spike on September 15, 1987, however, showed marked weakness remaining three months later.
I'm wondering if this article and others might not be looking at the TED spread the wrong way. I know, that's a bit of hubris, isn't it, for me to say so, especially when I freely confess that I'm just beginning to research the TED spread. However, bear with me as I explore. I was hired to represent the self-taught trader, the one exploring on his or her own, so let's explore.
Once the TED spread has spiked, I wonder, isn't the news already known? As the charts below will show, I'm wondering whether it might be better to look at the TED spread through contrarian eyeglasses. Waiting until it's over 1.5 might be a bit too late to discover that there's too much risk in the markets and move to protect equity longs.
If spikes above 1.5 are used as a measure, as Bespoke Investment Group defined a worrisome spike, the following chart from Bloomberg.com shows the TED spiking above that level in mid-August 2007, early November and again in early March this year. The SPX chart is immediately below. For ease in comparison, I've used the Bloomberg.com version of the SPX's chart, too, rather than my regular charts. Those don't provide a quote for the TED spread. Also, note that these charts were snapped a week ago and do not include current prices.
One-Year TED Spread Chart and SPX chart from Bloomberg.com:
Although I wasn't able to draw trendlines on these charts, a couple of points proved worth noting. A descending trendline can be drawn across the spike highs in the TED spread. A similar and parallel one can be drawn beneath the spike lows from August 27, January 27, and February 12 & 13. If one studies the spike highs as they're hitting the trendline and then compares SPX behavior, it's clear that the spike highs are either occurring well in advance of the SPX price highs . . . or, they're occurring as the SPX is already beginning to recover. That would go along with my theory that once the TED spread had spiked, the news was already known and markets had already reacted. Perhaps that was too late to think about protecting equity longs?
Now let's look at this from a contrarian viewpoint. To do so, study the places where the TED spread is coming down to hit the imaginary lower trendline, parallel to that descending top one. Note what happens to the SPX when the TED spread hits that lower trendline and then moves up through 1.0 again. For example, on October 15, 2007, the TED spread hit the lower trendline and by October 16, it had closed just under 1.00. On October 17, it closed at 1.20.
By then, SPX prices were already moving down some from their October 11 intraday high, but despite a sharp drop October 19, prices were to bounce again into their October 31 lower high. On October 30, however, the TED spread had again approached 1.00, testing it and closing just beneath it. Essentially, the 0.90-1.00-ish support was beginning to hold and the TED spread was in the process of completing a higher low while the SPX was completing its lower high. Then the SPX plunged as the TED spread spiked.
However, let's examine one case that refutes my whole theory. Got to be fair, right? The next test of the TED spread's upper trendline was December 12. The SPX was indeed beginning the process that would result in the long slide lower into the January low. A TED spread high and not a lower trendline support test occurred as SPX prices topped.
The refutation of my theory lasted into the next test of the TED spread's lower trendline was in January. By that time, the SPX had dived below its November low and was trying to consolidate. It was forming a triangle with an apex near that November low. The TED spread had dropped and, on January 16, 2008, the TED spread was again hitting that lower trendline. That's when the refutation of my theory stopped. As the TED spread dropped, perhaps hitting newly established support, the SPX dropped, too, closing at a closing low not seen since the previous March, when the credit woes first hit. However, by the January 18, the TED spread had again closed above 1.00, and the SPX was on its way into its January low.
By February 12, the TED spread had again hit that supporting trendline, where it sat through the 14th. By the 26th, it was testing 1.00 and on the 27th, it closed above 1.00 again. The SPX hit a lower high that day and then started down into its long slide into its March low as the TED spread spiked into its March high. From March 19-21, the TED spread was challenging that upper trendline again, closing above 2.00.
While the TED spread was hitting possible resistance, however, what was happening with the SPX? It had already hit its March intraday low on March 17. March 18, it gained sharply. March 19, it had reversed much of the previous day's gains. March 20, it reversed almost all the previous day's losses. Then, as the TED spread rolled down from resistance, it broke out again. By the time the TED spread had spiked that high, the news was already known and the SPX had begun stabilizing and then recovering.
As the Bespoke group warned, the evidence is mixed, but in my opinion, we should at least put on our contrarian glasses every now and then when viewing the TED spread. We should first keep in mind that these few comparisons made on these pages can be nothing more than anecdotal evidence. They're not conclusive and do not constitute any kind of definitive or analytical study.
We should acknowledge that the TED spread is not an exact market timing tool. However, with those caveats, perhaps when that lower trendline is being approached, as it is being lately, perhaps investors are taking on a bit too much risk for the climate. Perhaps they're doing a bit more dumping of U.S. treasuries and taking on of riskier securities, narrowing the spreads below more than is optimal for the market environment over the last year.
What about the possibility that the TED spread will eventually return to its previous range? As the previous text explains and the following chart shows, the TED spread remains well above that previous range.
Five-Year Chart of the TED Spread, Chart from Bloomberg.com:
Although it's always possible that the TED spread will return to its previous range, this climate dictates that we acknowledge the possibility of another bounce through that wide descending channel that can be drawn since last year and make appropriate plans. Those plans would acknowledge perhaps that there's too much risk in the market than is optimal in the current climate. Plans to protect bullish profits could be made, as I think should be done. As I revise this article on Friday, June 06, 2008, the TED spread had climbed to 0.87, still below the 0.90-1.00 that perhaps begins to signal some trouble, but climbing from its May approach to the supporting trendline.
What about when the TED spread is hitting the top trendline? That's a bit more problematic. Although equity markets had twice this last year already begun a recovery attempt by the time that top trendline was hit, that's not always true. In December, the TED spread was hitting the top trendline concurrently with a market top.
Also, due to the nature of the current worries in the market and the risks some still believe are looming due to the credit crunch and liquidity problems, I don't think we can always assume that the top trendline won't ever be broken. Still, if equity markets have already rolled over concurrently with a spike in the TED spread that carries it up toward that possible resistance again, those in bearish positions should also be aware of their risks as the TED spread approaches the top trendline again, if it does, and make plans to moderate that risk.
Unfortunately, my charting service does not provide quotes for the TED spread, and I can't find a historical source that goes back longer than five years. That means I can't conduct a more thorough study than has been done so far. Perhaps these last several years have produced actions that are so out of whack with norms that these observations will prove useless in the future.
However, by whatever method the TED spread is calculated and whether or not its
performance is mixed, investors should be familiar with the term and should keep
it on their radar screens. Bloomberg offers a free quote and charts, available
this link with the symbol TEDSP:IND. If there's a perception of increased
risk of defaults, we should probably know about that, don't you think?
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
Piazza, and all other plays and content by the Option Investor staff.
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