Wednesday, May 23, 2012

A directional indicator for the stock market

The market continued to be held captive to events, announcements and empty rhetoric emanating out of Europe.  I wasn't able to give much attention to the financial markets this week but I know the market staged a pretty impressive intraday rally today on some supposedly optimistic comments out of the Euro zone.  That all evaporated this evening when the EU meeting broke up in Brussels.  The market is liable to be very choppy in the next month up to the Greek elections.  I'll be speaking to all these issues in my upcoming Macro Analysis this weekend.

I thought I'd take a moment to show my readers a reliable indicator one can use to measure fear (and direction) of risk assets.  Many are familiar with the CBOE Volatility Index, popularly known as the "fear gauge".  In the current environment we find ourselves where risk assets move in unison either up or down based on fears of sovereign default and financial implosion I like to use the Three Month T Bill Discount Rate.  Let me show you:

(click on chart for larger image)

Short term Treasury bills are a global "safe haven" where institutional investors can park their assets when they are afraid to put them anywhere else.  These bills are extremely liquid and backed by the full faith and credit of Uncle Sam.  To understand the chart above you need to understand that yields on bonds, notes and bills move inversely to prices.  As Treasury Bill prices rise their yields drop and when their price drops yields rise. 

In the upper panel is a weekly chart of the Three Month T-Bill Discount Rate.  The bottom panel is a weekly line chart of the S&P 500.  I've constructed a red dashed vertical line on the two charts to highlight the nose dive in the Three Month yield in December 2008.  The Three Month T-Bill yield quickly recovered, and in this case, predicted the "V" bottom in March 2009 and the subsequent bull rally which I would argue we are still experiencing. 

The two vertical solid blue lines are meant to capture the period from April to December 2011 when the rate on the T-Bill tanked again.  But this time the yield stayed at record low levels for the entire period as frightened money created such a demand for this "safe haven" trade that yields stayed anchored at these levels.

Now, here's a daily chart of the Three Month T-Bill Discount Rate:

 I've pointed to the time when money started leaving this safe haven trade back in December when the European Central Bank embarked on its first Long Term Repo Operation (LTRO).  I've drawn a support line on the yield (blue dashed line) and you can see that we have pretty solid support at 0.55%.  Meanwhile, the bottom panel shows the S&P 500 and the significant correction it has experienced starting in May.  What this chart is telling me is that, in spite of all the volatility caused by fear in the stock market, the big money is still not that scared as the rate on the Three Month T Bill is still elevated.  I'll be watching for a break under 0.55% which would be signaling that institutional investors are getting more concerned regarding events in Europe.