Liquidity Zombies

Because of all the conflicting signals this market is throwing off lately, I have few very firm convictions about what is going to unfold over the next several months.

Since there is nothing to do as I see it, I'm not doing anything, with a couple of small exceptions I'll explain later. I remain fairly defensive. This leaves me very vulnerable to a sustained upward push in the market.

The dollar pessimism appears to have reached an apogee for the medium term, and I believe that the path of least resistance is now up for the dollar. Although my long-term view on the dollar is very bearish, I am now net long the dollar, but not by much. My US cash position is hedged with positions in the Swiss franc (FXF), the yen (FXY), and gold (GLD).

I retain several unsexy long positions in Berkshire Hathaway B-shares (BRKB), which has proven a surprising winner as a haven of liquidity in a liquidity-starved world, Johnson & Johnson (JNJ), and the Toronto-listed former Saskatchewan Wheat Pool, now called Viterra (VT.TO).

The fact that I am neutrally positioned does not mean I don't have expectations about what is likely to unfold, though. It just means that I don't currently see a way to exploit these expectations profitably.

For example, here is what I expect and am watching for . . .

I believe that the market is currently in a long-term topping process that is nearly complete. The sharp up days smack to me of short-covering, and are exactly what you would expect from counter-trend rallies. We've moved into a long-term trading range between bull (S&P above 1550) and bear (S&P below 1400) markets.

Where we break out from here should determine the direction for another year or so. My guess is that the direction will be down, but since I'm not forced to act on that sentiment, I choose not to do so. I'm no perma-bear. If we go up, we go up.

And when my money's all gone
I'm on the telephone

Hollering "Hey hey mama
Can your daddy come home?"
Johnny Horton, "Honky Tonk Man"

Unfortunately for the cause of real global growth, the threat of further US dollar flagellation by holders in Asia and the Middle East means that "Mama" (the Fed) has to think twice about using her money (liquidity) to bring Daddy (the broke honky tonk man) home.

I do find it difficult to imagine a new leg of the bull market beginning without a huge injection of liquidity of some sort or another, which would crush the dollar. However, the extreme negativity and the almost universal conviction that financials are in big trouble could provide more surprising pressure to the upside. So I remain agnostic.

Liquidity Zombies

Despite the current churning, I believe that there are some concerns bubbling beneath the economic surface that have not been fully discounted by the market. The world economy contains a number of non-self-financing, debt-reliant, easy money-coddled "zombie companies" that exist simply because of the lush liquidity environment of the past five years. Not only have these walking dead thrived under the unprecedented infusion of liquidity, but they have grown their tendrils around it, changing their function and their purpose to exploit cheap money.

We've already uncovered a couple of these in Fannie Mae (FNM) and Countrywide Financial (CFC), but the transformation of the US economy from a service to a financial economy has left many other companies--General Electric (GE) comes to mind--much more beholden to the credit markets than most people are generally aware. I also believe that liquidity has put much of the sheen on today's emerging markets, and that many high-flying "miracle economies" could find themselves in deep trouble very soon.

The Small-Cap Trap

Domestically, I believe the most fertile ground for such liquidity zombies, if they do in fact exist, is the small-cap arena. It's important to remember that there was a time when large companies commanded a premium in the marketplace to small companies because of the much greater likelihood of failure among these small companies.

No longer. The iShares Russell 2000 ETF (IWM) is priced at 17.7x earnings versus the S&P 500's 15.7. The Russell 2000 has well outperformed the S&P since 2000, a long enough period that there are many people in the market today who have never encountered a real small-cap bear market.
Having never experienced a brutal small-cap bear market personally, they follow age-old Wall Street custom and deem such a thing impossible.

The big picture supply-demand of stock supports this view. Small-caps seem to have begun a new downtrend, marked by lower highs and lower lows. This seems to be a crowded trade, but there should be enough room for everybody.


I've been taking occasional shots at these on the short side via TWM (the Russell 2000 UltraShort), without much success so far.

If the current illiquidity does not get better, and quick, I believe the carnage among the small-caps will surprise a lot of people.