Last week I shared a strategy that used the TED spread to trade the stock market. That post was one of our most read ever and we received a number requests from readers for more performance data. So in this post I’ll explore the TED strategy results from the perspective of an investor employing it in the real-world.

(logarithmically-scaled)

The graph above shows strategy results trading the S&P 500 (blue) relative to buying and holding the S&P 500 (red) from 1988 to 11/07/2008. Previously, we showed the strategy in monthly intervals; the graph above is daily. This strategy spends more than half of all months in cash, so here I’ve made things fairer by assuming that we received a return on cash equal to the nearest 13-week US treasury rate.

And for the number lovers:

In case you missed my previous post, this strategy was taking a contrarian approach to the TED and going long the S&P 500 when the TED spread was expanding, or in technical parlance, when the 6 month exponential monthly moving average (EMA) of the TED was increasing. See geek note at end of post.

This strategy hasn’t been a huge earner, but it has done an excellent job of reducing the volatility of the broader market (by about a third) and sidestepping major drawdowns over the last 20 years…that is with the exception of our most recent in 2008.

As yet another illustration of how October bucked just about all contrarian trading models (which I’ve discussed before), the graph below shows strategy drawdowns since 1988. Notice how well the model managed downside loss (never exceeding -15%) until October hit the “oversold” point and then just kept on falling.

This strategy could very easily be applied in the real-world using a number of vehicles including ETFs or mutual funds. It’s pretty low on the “hassle scale”, only averaging about 5 position changes per year. This test was frictionless, so real-world considerations such as taxes and transaction costs would have to be considered in each investor’s unique situation.

I don’t think this is an end-all-be-all strategy (and certainly not as effective as solid short-term trading…shameless plug), but I do think it’s a world better than most of the strategies in use and an interesting addition to other long-term trading systems such as 50/200 day MA crossovers.

Happy Trading,
ms

Geek Note: There are two generally accepted ways to calculate an EMA that produce slightly different results. Here I’ve used the ((1/Period)*2) method. If your charting program uses the (2 / (Period + 1)) method, simply reduce my period by one. For example, if I’ve used a 6 period EMA, the alternate EMA would be a 5 period EMA.