On Friday, May 21, the SPX and many other indices opened lower than the previous day's close. The SPX quickly ran down to a historical support level in the 1055 zone while the Dow pierced 10,000. The SPX had also tested the bottom of a steeply descending parallel price channel in which it had been descending for more than a week.
Neither stayed at the day's lows long. One strange signal had put knowing bears on alert. The VIX, sometimes known as the fear gauge, had popped up at the open but it soon was falling. Since the VIX usually moves in opposition to the price action, one or the other was wrong. The alert bear could prepare for a possible bounce from the support zone being tested. The VIX was to tumble throughout the morning until it steadied and ran up to a lower high in the afternoon. On Monday, May 24, it started out the day climbing.
But another gauge had alerted me that the markets might not have bottomed just yet. There might be more downside to come, as it turned out that there was. That Friday evening a week ago, I pulled my poor not-interested husband into my study and pointed out what I was seeing in another chart. That other chart was the TED spread's chart.
The TED spread also tends to move in opposition to equity prices, although it shouldn't be used as a market-timing tool. The TED spread hadn't pulled back at all on May 21. In fact, it had closed at a level not seen since July, 2009. Back in July, 2009, when it was last at that level, it was running down from the all-time highs it had first charged up through in July and August, 2007. The TED spread had stayed above those levels straight through July, 2009. And now it was rising again.
Bloomberg Five-Day Chart of the TED Spread, 5/19-5/26:
Resizing requirements rendered this chart a little blurry, but the trend of the TED spread remains quite clear.
In this April 16, 2010 Trader's Corner article, I had explained how the TED spread was calculated, pointed out its significance, and noted that some troubling developments should be watched. At that time, the TED spread had been forming an inverse or reverse head-and-shoulders formation, with the neckline also coinciding with a long-term descending trendline. "A break above those trendlines might be a heads-up that underlying conditions are changing, while another sharp downturn beneath those trendlines might signal all-clear ahead to the ongoing rally, at least for the time being," I had written in that article.
Bloomberg Six-Month Chart of the TED Spread, Showing Break of the Inverse H&S Neckline:
That neckline and a long-term trendline not shown on the chart were broken to the upside on about April 26, 2010. At that time, the TED spread charged up above that neckline and trendline. It moved back into the 20-50 basis points spread that had been typical for the TED spread before the 2007-2009 period. That period's uncertainties had sent the TED spread soaring above historical norms. Then the post-March, 2009 rally had sent it careening down below historical norms. I had concluded that April 16 article by saying that "if the TED spread breaks up through those trendlines and especially if it climbs back into its old 20-50 range and keeps going higher, I'll be paying attention. I'll make sure that all my income trades have insurance puts."
The TED spread, a spread between our three-month treasury futures and the three-month Euro dollar futures, could prove helpful for all of us to watch in our global financial current situation. The blurriness rendered by the need to resize the chart for publication make it difficult to read the levels on the side of the chart, but as of May 28, the TED spread was 38.11 basis points, still charging higher.
What should we watch for now? As long as the TED spread is charging upward, we should remain aware that such a trend signals that there's still a lot of uncertainty in financial markets. As default risk is considered to be rising, credit may be tightening to uncomfortable levels. Such actions are not good for equities, which tend to behave badly under such conditions.
Bears should be aware, however, that historically, the 50-60 zone usually caps most advances of the TED spread. For example, in late September and early October, 2005, the TED spread was topping out just above 50, and in early through late December of that year, it was again topping out just below 60. As the TED spread was topping in September and October of that year, the SPX was retesting the summer's low before charging higher. In December, as the TED spread was again topping, the SPX was consolidating sideways in a broadening formation before charging higher again. TED spread movements often precede or accompany equity movements, predicting or corroborating them.
So far, the TED spread shows no signs of topping, and a continued move higher such as the extreme trend that occurred during the recession signals that the danger of defaults remains high. It would be a good idea to pay attention to the TED spread as it tests what were historically its highs. Don't assume that the TED spread will roll down again from the 50-60 basis-point level, but do be watchful.
Let equity price action be your guide after or as the TED spread warns. In other words, don't plow into bullish trades just because the TED spread hits highs in the 50-60 region. It didn't stop there in late 2007 and, by late 2008, was hitting what I believe to be all-time highs. If current Eurozone conditions and worries worsen, that can happen again, and we all know what happened to equities during that period.
There's also a pattern of the TED spread that it may be helpful to watch if there is a rollover from that traditional resistance level. When the TED spread rolls down, it often comes back comes back up to retest, with equities often hitting an equal or lower low while it retests. Whether the TED spread again zooms up through what has traditionally been resistance or rolls down from that level, let the TED spread signal you to prepare your just-in-case plans but act only when equity prices confirm. A first TED spread rollover from the 50-60 level doesn't necessarily mean that a bottom has been reached. A retest may be required, so if the TED spread and equity price action seems to suggest a bullish entry, be prepared to step right back out again if the TED spread pushes up toward 50-60 again and equities roll down again. A retest may be taking place.
For those who would like to watch the TED spread for themselves, Bloomberg is the only site I know which offers the quotes. Their charts are rudimentary at best but good enough to view what you need to view. You can find them here.