Education Newsletter

There has been a lot of talk recently about whether the VIX is the tail wagging the dog, and I thought I would chime in on the subject.

The CBOE Volatility Index has clearly seen a lot of strange action lately. February had the most days with the S&P 500 and the VIX climbing together, as opposed to their usually inverse relationship. And then there was the volume explosion in the VelocityShares Daily 2x VIX Short-Term Futures (TVIX) exchange-traded note, which stopped creating new units.

This week we have seen huge swings in the spot VIX, as it first dropped below 15 and then below 14--if briefly--for the first time in five years.

What does this all mean? Let's break it down backward.

Basically, the VIX is based on a calculation that includes all options with a bid. If, for instance, a bid was pulled from an option higher of a higher strike, all the lower strikes are dropped from the calculation.

So as the bids were pulled and then replaced, the VIX swung wildly. The moves in the VIX, especially yesterday, are nicely explained by Jamie Tyrrell in our Volatility Sonar report.

At the same time, however, the volatilities of options that were actually trading were not changing, and the VIX futures weren't moving much either.

As I've always said, it's important to remember that the VIX is simply a statistic that can be moved by quirks--not the Holy Grail that some posit. This does not mean that it's without merit;  its usefulness is most notable in relation to other measures of volatility, like the actual volatility of the SPX and the VIX futures.

But can we rely on the VIX futures anymore? Some say that the VIX-based exchange-traded funds and notes, such as the TVIX and the iPath S&P 500 VIX Short-Term Futures ETN (VXX), are unduly influencing the VIX futures market. The VIX isn't tradable and all of those VIX-based products are based off the VIX futures.

We have seen very steep contango recently, with a big premium in the front-month VIX futures and increasing premiums all the way out in later expirations. So right now the VIX is at 15.45, but the March futures that expire next week are at 17.45, the April contracts are at 21.45, and the September futures are above 27.

The action in the exchange-traded products may be helping to drive that steep contango because they sell nearer-month futures and buy later-dated contracts. Some market observers contend that these funds and notes of own all of VIX futures.

But the TVIX stopped creating new units a while back. And while volume as taken off in the ProShares Ultra VIX Short-Term Futures ETF (UVXY), another 2x short-term fund, it is still about 10 percent of the peak volume in the TVIX. Likewise, volume in the VXX has picked up but remains well off its highs.

Even so, yesterday saw more than 92,000 VIX futures trade, right around the levels from when the TVIX volume spiked higher. This has pushed the total open interest in VIX futures to more than 308,000, which I believe is a record high, but the day-over-day change in open interest was only 11,000 contracts.

So it appears that the vast majority of the action in the VIX futures is intraday, and that doesn't strike me as hedging action of the firms running these VIX-based funds.

It used to be that steep contango in the VIX futures meant that smart money was betting on higher volatility in the near future, and they were usually right. But since 2008, and especially since the inception of the VIX exchange-traded products 2009, the steep contango has not necessarily preceded equity selloffs.

What all of this means is that volatility analysis is a dynamic process. A VIX of 15 doesn't mean anything in isolation. And the type of steep contango we have right now has really not been seen before, so it is impossible to draw any hard conclusions.

Much the same can be said for those increasingly popular VIX-based funds, which are still relatively new. They ultimately may reduce the volatility of the market, or they may increase it in times of stress.

It's time to jump on the bandwagon and buy the banks.

I know they're up a lot recently, but they still have room to run. Consider this fact: The Financial Select Sector SPDR exchange-traded fund (XLF) has led the major sectors higher in the last 3 to 6 months. But over the last 12 months, it's still down the most.

The XLF remains about 11 percent below its highs from last year, while the S&P 500 is above that respective level on its chart. And the XLF is still at less than half its peak level in 2007, while the S&P is only about 11 percent off its all-time high.

One of the easiest ways to make money is to invest in real companies where fear has been misplaced. I say "real" because some companies are truly doomed for legitimate business reasons: the tech stocks in 2000, subprime lenders in 2008, and solar stocks today. There was a time when the market imagined something similar might happen with the banks, but yesterday's stress-test results and dividend increases now indicate that those worries were nothing but a fantasy.

And I speak from experience, as I was one of those people who envisioned their demise. I had, after all, done a lot of research on the degree of messiness in their mortgage portfolios, and had discerned some real tomfoolery in their accounting practices. I was probably about half-right in my worries.

But you can only focus on stuff like that for so long before you realize that you're living in the past. This is 2012, and banks have been deleveraging for more than three years. We'll never know the full extent of the corruption and fraud that occurred during and after the subprime crash--but we do know that it's over, and it's time to move on.

Lots of money can be made because the banks are underowned. Many trade below book value and are now increasing dividends. The speed with which JP Morgan and U.S. Bancorp raised their payouts after yesterday's stress-test results speaks volumes. Others will follow.

Those are "value" considerations: Banks are too cheap based on the status quo. But there is also a "growth" consideration: Banks stand to benefit from improving demand and business activity.

In a little-noticed detail of the Federal Reserve's last Z.1 Flow of Funds report, U.S. commercial lenders (Table F.110) reported that non-mortgage bank loans grew at a $245.6 billion annualized pace in the fourth quarter. Not only was that a record, but it also increased by more than 150 percent since middle of the year.

In other words, at the same time everyone was sweating bullets about Greece, U.S. banks had already begun growing their balance sheets. That's bullish.

The same report showed that net mortgages (Table F.217) contracted at a $209.9 billion pace,
versus a $303.7 billion decline in the third quarter and $384.1 billion between March and June. In fact, it was the smallest reduction since the first quarter of 2009!

Also consider these facts straight from the Fed's last loan officer survey. Again, remember all of these things happened at the same time that panic was sweeping Europe:

• Banks are easing lending standards to win business.
• Business-loan demand was the strongest since 2005.
• Banks are lowering borrowing costs and extending maturities.
• Terms on commercial real-estate (CRE) loans are loosening for the first in five years.
• Most banks expect fewer defaults on CRE loans.

These are the ingredients of a real bull market, and there are countless ways to play it. The simplest could be with a vertical spread on the XLF. Consider buying the September 16 calls and selling the September 17s, paying $0.45 or less.

Following yesterday's bullish news, I believe it's highly likely that the fund will go back to its long-term peaks around $17. This strategy will roughly double your money if that prediction is correct.

Disclosure: I own the Direxion Daily Financial Bull 3x Index Fund (FAS), which is triple leveraged to the XLF.