A lot can change in two weeks. I have been half a world away since mid-September, during which the Fed announced "Operation Twist II," Italy and her banks were downgraded, along with Bank of America, Wells Fargo, and the Greek banks. Stocks predictably declined on all of this news, although not by very much. Only today, after continued discussion about the breaking up of Dexia bank, did the S&P finally decline 20% from the prior highs, technically making this a bear market.

That's the proper appellation for the market, despite the 4% rally in the final forty minutes in a furious short-covering move triggered by the shocking, shocking, rumor that the EU is thinking about how to recapitalize European banks. Bloomberg attributed the rally to comments by Olli Rehn, carried in the Financial Times, that there is an "increasingly shared view" about the necessity for coordinated action on the crisis.

Obviously, that is anything but news. The real reason we got the rally is that stocks didn't break after passing below recent lows, and shorts chose to cover (and then, as the rally gained steam, were forced to cover) rather than take headline risk overnight.

Late in the day, an announcement was made that Dexia would be split into a bad bank and a less-bad bank and massive guarantees put into place from France and Belgium. Two countries breaking up and backstopping one bank isn't exactly what I would consider 'coordinated action' on the crisis, but who am I to question the French?

But headlines aren't really all that important right now, in my view. If they were, then we certainly got plenty of them today from Fed Chairman Bernanke - and it didn't move the market. In testimony before Congress, Bernanke stated (in some cases, as paraphrased by Bloomberg):

• Inflation has begun to moderate. Well, it is, but it's headline inflation that is moderating. Core inflation is accelerating.
• The Fed is prepared to take further action as appropriate. It hasn't been appropriate since (arguably) 2008. I think he means "if we continue to be scared at the prospect of continued healing."
• Recovery from the crisis has been much less robust than hoped. Yeah, absolutely true. Specifically, we're experiencing another crisis.

Seriously, the failure of the market to respond to a promise that the Fed is prepared to keep on firing both barrels, even if the gun is loaded with expensive blanks, was surprising. Either the Chairman's credibility is waning, or the market's confidence that further Fed action is a good thing is evaporating, or both. I personally think that's appropriate.

I must say that I am amazed to come back to find nominal yields even lower than they were when I left. I did write on September 5th about the strong seasonal pattern in bonds and that "the window for a selloff is closed for now," but I must admit I was skeptical that yields would actually fall from the 1.99% level on the 10y note where they were at the time. We are indeed approaching a point (on the calendar and on the yield level) where shorting bonds in anticipation of a year-end liquidity washout may make sense. I will be looking for an opportunity to do that over the next couple of weeks.

Now that most people seem to expect Greece to eventually default - which has been my base case for more than a year - the opportunity to short bonds might occur once the announcement actually happens. I expect that if/when Greece does throw in the towel, we'll also get a perverse rally in equities as well. The reasoning will be that 'the worst is behind us and they have had plenty of time to prepare for this.' This trade surfaces from time to time, and it's always maddeningly stupid. Stocks will rally when this happens, after an initial dip, and we will all pull our hair out because we know the next trade after that will be the realization that even though banks and others have had plenty of time to prepare, all of the actions of the politicians to date have been designed to prevent any such preparation (by, for example, marking bonds correctly or selling them).

Stocks, too, are again approaching levels where it may be appropriate to start buying to get closer to a neutral position. Our 10-year projections for equities' real returns (which were only 2.58% at year-end 2010) have now risen to 3.4%. That's pretty slim, but it's getting better.

At the same time, commodities are also growing more attractive. The knee-jerk reaction to the 'growth slowdown' trade, pushing the dollar higher in a flight-to-quality and commodities lower, is predictable but nonsensical. The current circumstances augur increasingly desperate monetary policy maneuvers, as Bernanke hinted today are still on the table. While the dollar could conceivably rally because other countries' central banks might out-print the Fed, there is no question that a large majority of the world's meaningful central banks have their fingers hovering over the monetary print button. As I've written repeatedly, the supply/demand analysis of commodity prices, which suggests lower prices due to slackening demand, is myopic in an environment when the value of money relative to real stuff is highly likely to diminish appreciably. I am not talking about one particular commodity here, but all commodities (and to a lesser extent, real estate).

However, I am not anxious to jump into these asset classes, nor to short bonds just yet. Partly, this is because I think there is a fairly large chance that we are still due a big crunch in Europe, but partly because I haven't seen any sign of a washout yet. I am intrigued with the behavior of the VIX (see Chart, source Bloomberg), which has been doing something really remarkable. After the spike above 45 in early August, it has never retreated below 30. For two months, it has remained elevated without spiking further. This is unusual, as I think the chart makes clear. Ordinarily, the VIX will spike, then retreat. It almost never spikes, then remains at that level.

What goes up, must come down. Or mustn't it?

Sometimes, on the way down, the VIX will pause and consolidate at an elevated level, as in early 2009. But on the way up - frankly, I can't find another example of the same sort of behavior.

The bullish interpretation of the phenomenon would be that investors have been aggressively buying insurance for a while and so won't be pressured to sell if the market declines further. But this interpretation ignores that there are as many sellers of options as buyers, and those investors will need to sell to delta-hedge shorts in a decline (or vice-versa in a rally). Ordinarily, short-gamma investors are more anxious to delta-hedge than outright long investors, but my main point here is that the bullish interpretation doesn't hold much water. The bearish interpretation is just that the initial spike in the VIX apparently was not considered overdone, as spikes usually are...and that makes me wonder what is next.

Strictly speaking, what is next is ADP tomorrow. The consensus call for 73k new jobs seems to me a little optimistic on the heels of an overshoot last month (in the sense that last month's 91k on ADP overshot the 0k on Payrolls).

But then, optimism is still out there. For example, despite the fact that I can't think of a single "good bank/bad bank" plan that has ever actually been consummated as such, they keep being proposed and the market keeps acting as if it's a terrific idea. But there's a reason such plans don't actually happen. Suppose you are a Dexia bondholder and the firm splits into two entities. To which entity does the debt belong? Bondholders will surely object if they suddenly have bonds of a "bad bank" as the good assets are cleaved off. But if the debt goes with the good bank, then how good of a bank is it? Equity holders don't mind holding pieces of both, because a portfolio of two options always has at least as much value as a single option on the conjoined underlying, and usually more. But bondholders have the opposite problem, and since the creditors typically have rights they can be counted on to object. So a good bank/bad bank split only happens if the government takes the bad bank (as, for example, when the Fed agreed to take the "Maiden Lane" assets out of Bear so that JPM could consume the 'good bank').

And if France and Belgium take the bad bank, with its €566bln in assets as of year-end (thanks to Peter Tchir for that number), then how long will those entities retain their own ratings? No, I think there is plenty of room for optimism to turn less sunny, and so I wait with my equity-buy and bond-sell lists ready, but don't expect to use them for a little while yet.