TED spread and LIBOR

Markets are a discounting mechanism that take all available information into account. Prices will rise or fall in anticipation of news, and prices can react in a variety of ways to the news. The current financial crisis talked about so much in the news has created an extreme in volatility. Panic leads to selling. Hope of a bailout leads to buying. These two, panic and hope, are swinging the market violently. This is good for day traders but unsettling to say the least for most investors.

The TED spread is the difference between the interest rates on inter-bank loans and T-Bills. TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract. The TED spread is calculated as the difference between the three-month T-bill interest rate and the three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). The TED spread is a measure of liquidity. As such, the TED spread is an indicator of perceived credit risk in the general economy. The TED spread and LIBOR rates can be viewed as indicators quantifying the confidence banks have in lending to each other and the financial system as a whole. In calm markets the LIBOR is about 1/2% above the yield on the US debt.

The chart below shows how since August when the TED spread was at 1% it has spiked up to 3%. This is associated with the recent credit crisis and bank failures and a massive effort by the government to inject liquidity into the system. It shows that the confidence banks once had in lending to each other has dried up and that now banks are hording cash. The $700B financial rescue plan expected to be voted on tomorrow should show a significant change in the chart below should it be passed. We will just have to wait and see. Click on chart to enlarge.

Market Summary

This weeks market summary will serve as a good reference point which to look back upon as we are in the middle of the current financial crisis. Compared with the last market summary right off the bat I can see that gold has gone from flat for the year to being up 2.10% and has traded places with the Russell 2000 index which was slightly up for the year last time to being down 6.47% now. In fact gold and the Russell seem to go in opposite directions as seen by their respective moves over the last 4 weeks: gold is up and the Russell down both by 5%. Perhaps these two could be used to create an indicator for the direction of the markets. Click on table to enlarge.

Filling The Gap

Following the low on the chart below there are two large white candles with a gap in between them that occurred between September 18th and 19th. Markets abhor a gap and we have filled that gap yesterday and today. Not only that, the chart pattern that has formed is known as a Cup and Handle formation. That is very bullish and I expect the market to rally soon. With the bailout package expected to be passed before the congressional recess I anticipate a rally to take out the 1260 high. That is how I see it. We will just have to wait and see. Click on chart to enlarge.

Market Summary

As can be seen from the table below, which is sorted by Year To Date, the only indexes in this list that are in the green are oil, gas, and the Russell 2000 index. What is interesting about the Russell is that it is the riskier of the major market indexes and can be a proxy for risk appetite. The more conservative index, the S&P500, is down 13-14% for the year. And gold is flat. And what was the darlings last year, the international and emerging market indexes, are the worst now down over 20%. Click on table to enlarge.
Also note that while this may not be the bottom of this bear market we did call a bottom as can be seen from the chart below. How much rally is left remains to be seen. 1140 in the $SPX index is the same as 114 in the SPY ETF. Just to give some perspective, the rally off the lows to the close as seen in the last 4 bars of the chart must be in the billions of dollars. Click on chart to enlarge.

Buy Low Sell High

This is the key to making money on Wall St., or on Main St., or on any street for that matter. It is, however, easier said than done and particularly on Wall St. There are two factors that are needed to make use of this key: liquidity and volatility. I made reference to these factors in my prior post on capitulation. Capitulation is determined by a spike up in volume (liquidity) and volatility. It can be reduced to a number and therefore determined. I will briefly give one method here.

In order to buy low you have to be a contrarian and have the discipline to buy when everyone else wants to sell. When there are massive sell offs in the market is exactly the time to buy. I am not referring to a particular company which may be going bankrupt but rather an index fund that represents the whole of the market. When the volatility is high it means that there is a panic. Panic is fear and fear will cause people to sell at exactly the wrong time. That is what happen today. When they sell the price is cheap and a good time to buy.

Market bottoms come when the volatility index is over 30 and the volume spikes high. One way to reduce this to a single number is to multiply the two numbers and keep track of the product of the two. On the day of capitulation the number will be the highest compared to the number on the days before and after. For example, one would multiply the $VIX index times the volume as follows: 33.10 x 10715096 = 354669677.6

I am including the same charts as I posted in the prior post to give a before and after view. I believe that today was capitulation. We will just have to wait and see.

NYSE TOTAL VOLUME


VOLATILITY INDEX


SPY daily chart

As can be seen from the charts above there is a correlation between the price of the SPY which I use here as a proxy for the market, Volume, and Volatility. While this pattern does not show up often, it does mark bottoms in the market. The market does however have many bottoms and will no doubt have many more.

Capitulation

Capitulation is a term that means surrender. As such it is a military term were one side gives up to another. In fact, the root of the word is “head” and in this context refers to the heading of an agreement for surrender. When applied to markets it generally refers to the end of a downtrend where the bulls give up and sell. It is in fact the best time to buy. It is accompanied by high volume as everyone is rushing to the exit at the same time and high volatility. This can be seen by a spike in volume and in the volatility index. Notice in the charts below how in the middle of July when the market reached a bottom the charts for volume is at a high and the chart for volatility is also at a high. Click on charts to enlarge.
NYSE TOTAL VOLUME

VOLATILITY INDEX

SPY daily chart

As can be seen from price action of the SPY daily chart above the market has entered a new downturn. Will the Fed bailout of Fannie and Freddie save the market? It may give a bounce but we will just have to wait and see if it brings capitulation.