Yesterday’s close of the Dow marked the smallest daily net change in the stock market since June 30th. In October, the average range between the daily high and low was an astounding 594 points. At long last, I think we can see some decreasing volatility in the market. The key driver of calmer trading is the growing realization that the risk of a systemic meltdown in the financial markets has passed. One excellent measure of that is the TED Spread, the spread between the 3-month Treasury Bill and the 3-month LIBOR rate (the rate at which the most creditworthy banks lend to each other). The TED Spread was once a well-recognized speculative trading strategy (I was E.F. Hutton’s TED Spread analyst in 1986-87). For a decade, no one has cared about or followed this relationship because it was no longer tradable and it had virtually no volatility. However, it has been a very strong indicator of underlying problems in the markets — the spread widened dramatically before the Crash of 1987, for example. Unfortunately, nobody noticed when the spread broke out of its narrow range last August — this should have been an early warning signal for all of us. Last month the spread spiked dramatically. What is important looking forward is that the spread has now narrowed by over 200 basis points — at last we are on the “right” side of this curve. Based on past experience, it will take several more months at least to return the spread to more normal levels, but we are heading in the right direction. This spread is important fundamentally, because many short term commercial interest rates and adjustable rate mortgages are closely linked to LIBOR — the narrowing of the TED Spread implies that the Federal Reserve will regain the ability to impact these rates and that the central bank’s easing policies will be able to impact the economy.
Less Volatile Markets Ahead
The passing of systemic meltdown risk means that investors will be focused on valuation and earnings risk. With valuations quite cheap in turn, we expect volatility to be a function of earnings surprises. The markets are used to this type of risk and valuations this low often cushion downside. While none of this ensures a bottom, it should lead to a market which trades with more normal levels of volatility.