Portfolio Design

Advanced concepts in stock investment portfolio design.  Fundamentals, technical analysis and many other related topics are discussed.

Timing the Market with Perceived Credit Risk

The TED Spread indicates the perceived risk of inter-bank loan defaults.  Can the TED Spread be used as a general market timing indicator?  Some basic backtests give us the answer.


"The TED spread is the difference between the interest rates on interbank loans and on short-term U.S. government debt ("T-bills"). TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract ... as represented by the London Interbank Offered Rate (LIBOR)."  - Wikipedia

The size of the TED spread usually fluctuates between 10 and 50 bps except during times of financial crisis when the spread can rise to several hundred basi points. When the spread rises it signals that lenders believe the risk of default on interbank loans is rising. When the risk of bank defaults is perceived to be decreasing, the TED spread in turn decreases.

Can perceived credit risk be used to time the market?  The answer appears to be YES, as demonstrated by one single backtest rule using Portfolio123.

Market timing using exponential moving averages of the TED Spread

I call this the RiskOn-RiskOff rule.  When the 50-Day Exponential Moving Average (EMA) is above the 200-Day risk is OFF. Likewise, when the 50-Day EMA is below the 200-Day EMA risk is ON.

The backtest results show that risk is off for some of the recent volatile periods in the stock market, including most of 2008, late 2011, and late 2015 / early 2016.  Note that risk has been off since early 2014 until the present.

RiskOn-RiskOff simulation using Equal-Weight S&P 500 ETF (RSP) and Short Term Treasuries ETF (SHY) 

RiskOn-RiskOff simulation using Equal-Weight S&P 500 ETF (RSP) and Short Term Treasuries ETF (SHY) 

This indicator was in the RiskOff state for periods of time during the 2003-2006 expansion. To improve results one should use the TED Spread in tandem with other market signals to achieve more aggressive performance. (OK I'm just realizing after capturing all these graphs and data that it might be worth exploring the absolute level of the TED Spread as opposed to difference in moving averages. Oh well... another day's work)

Please keep in mind that the 50-day / 200-day parameters are optimized.  Out of sample results will vary and performance will likely be somewhat lower.

If you want to take a more aggressive approach, then try substituting Intermediate (IEF) or Long Term Bonds (TLT) for SHY.

RiskOn-RiskOff simulation using Equal-Weight S&P 500 ETF (RSP) and Intermediate Treasuries ETF (IEF) 

RiskOn-RiskOff simulation using Equal-Weight S&P 500 ETF (RSP) and Intermediate Treasuries ETF (IEF) 

RiskOn-RiskOff simulation using Equal-Weight S&P 500 ETF (RSP) and Long Term Treasury Bonds ETF (TLT) 

RiskOn-RiskOff simulation using Equal-Weight S&P 500 ETF (RSP) and Long Term Treasury Bonds ETF (TLT) 

RiskOn-RiskOff simulated year-by-year results using Equal-Weight S&P 500 ETF (RSP) and Long Term Treasury Bonds ETF (TLT) 

RiskOn-RiskOff simulated year-by-year results using Equal-Weight S&P 500 ETF (RSP) and Long Term Treasury Bonds ETF (TLT) 

RiskOn-RiskOff simulated trade statistics using Equal-Weight S&P 500 ETF (RSP) and Long Term Treasury Bonds ETF (TLT) 

RiskOn-RiskOff simulated trade statistics using Equal-Weight S&P 500 ETF (RSP) and Long Term Treasury Bonds ETF (TLT) 

This system isn't just for S&P 500 and treasuries. You are pretty much limited only by your imagination when it comes to risk on / risk off trade instruments. Another example is consumer discretionary/staples as you can see below.

RiskOn-RiskOff simulation using Consumer Discretionary ETF (XLY) and Consumer Staples ETF (XLP) 

RiskOn-RiskOff simulation using Consumer Discretionary ETF (XLY) and Consumer Staples ETF (XLP) 

A note of caution here..  money-market reforms are set to come into effect on October 14, causing a spike in Libor. I'm not sure how that ultimately affects this timing system.

All for now