VIX Is The Best Way To Play Today's Irrational Market

Includes: VXX
by: Colin Lokey

Thursday was a good example of what can happen when you're a bear in a market that takes its cues from central bankers instead of economic data: you can lose money even when you're general thesis is correct. Initial jobless claims rose 13,000 to 380,000, disappointing economists and bulls who were expecting claims to fall to 355,000. To make matters worse, claims from the previous week were revised upward to 367,000 while the four week moving average also rose, hitting 368,500. This should have been good news for bears, especially considering the dismal March NFP number released last Friday.

However, in yet another example of how addicted the market is to central bank stimuli, dovish comments from Bill Dudley, president of the Federal Reserve Bank of New York, saved the day for stocks as he seemed to indicate that QE3 may be on the horizon after all. In a speech given in Syracuse, Dudley (a dove) echoed the sentiments so often espoused by Bernanke over the past several months, noting that regardless of the 'incremental' improvements in the U.S. economy occasioned by unseasonably warm weather, the 'slack' has yet to be picked up in full, a fact which supports the contention that the U.S. needs more stimulus. Dudley also noted that inventory accumulation likely accounted for most of the growth in last year's fourth quarter, a fact which, if history is any guide, presages a significant slowdown in inventory accumulation during the first half of 2012. The economy needs to grow at a faster rate to absorb excess production capacity Dudley said, noting that the growth rate during the first quarter was just barely in line with the 'potential' growth rate.

Dudley's speech lined-up nicely with comments from Janet Yellen (vice chair of the Federal Reserve Board) who indicated that she too was less than satisfied with the recovery. We all know that the Fed has indicated further QE will be 'data driven'. The real question is: How much data is enough to drive the Fed to pull the trigger? Probably not much--at least that's the message the market sent Wednesday by rallying nearly 1.5% across the board.

It looks increasingly likely that the FOMC will indeed announce a third round of quantitative easing at its June meeting. Perhaps the only reason to think otherwise is that Bill Gross is betting on QE3--it might be good idea to bet against the 'bond king' as his last big bond bet (against Treasury bonds early last year) went horribly wrong.

In all seriousness, bears (and I am one of them) have found themselves in a rather peculiar position lately: the more right we are, the more wrong we become. The worse the economic data, the more likely it is that the Fed will implement QE3, and hence the more stocks rise. This has been the case nearly without exception lately. The only time it has failed is in the face of extremely disappointing economic reports such as the big NFP miss last week. In this sort of environment it is beginning to seem foolish to try to bet on which way the market will go--especially with earnings season representing yet another wild card. One thing is virtually certain however. Anytime the VIX term structure gets too steep (as its been prone to do lately) it tends to snap-back, creating an opportunity to bet on a rise in the VIX when the spread between it and longer-term implied volatility widens too much. Long VIX on significant dips in volatility like the one which took place Thursday.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.