Absolute Strategies Fund Q210 Portfolio Commentary
Absolute Investment Advisors
Jay Compson
July 29, 2010
If deleveraging trends persist and embed themselves into the economy, markets will need to adjust to the reality that the potential for deflation is a real risk. Labor, real estate, and state and local governments are structurally challenged as a result of weak consumer activity and limited credit availability. We expect heightened volatility in the credit markets given the re-pricing of troubled sovereign debt and the potential for those concerns to catch up with the "Amend, Extend & Pretend" refinancing of corporate debt. While many companies do have solid balance sheets, there is a wall of debt coming due over the next few years. This, combined with default expectations of just 2.7%, which is already below the 40-year Moody's average, may set up investors for surprises and disappointment. In fact, "distressed debt" could be referred to as a "mini-bubble" as a flood of money into the space has resulted in surprising complacency. This could create an incredible opportunity for strategies that have true valuation discipline and are able to take advantage of distressed prices in both equities and credit.
Particularly concerning presently is the varied banter from policy makers who on the one hand believe we have a sustainable recovery, but on the other hand, want to introduce new stimulus to "create demand." There has been a continuous misallocation of capital through all the Fed and government's simulative adventures and policies over the past decade-plus. It is worrisome to imagine how badly a new flood of money could create unintended consequences for an economy already buried in too much debt. Our economy needs to correct at least a decade worth of artificial demand, overconsumption, risk taking and greed. Yet, many academics believe they can create sustainable jobs and growth through more artificial demand and more risk taking. This debate is unlikely to be resolved smoothly.
Consider how nonsensical things are today: Much of the mess we find ourselves in was enabled by the government's desire to relax lending standards so everyone could get a loan. Banks lent money to those who should not have been lent to resulting in banks not having enough of a capital buffer. These same banks then had to be bailed out in order to save the financial system from collapse. Since then, banks have reined in their abusive lending practices and now hold more capital. However, the Fed and the government are not happy that money isnÃt flowing (especially with elections approaching), so there is discussion to change the rules regarding interest payments banks receive from the Fed. This could again force banks to lend to those who want loans (but aren't credit worthy of those loans), while at the same time depleting their capital buffer. (As a side note, a primary reason small businesses owners cannot get loans is because their largest form of collateral has generally been their home or building, which have dropped in value substantially.)
Against the obvious risks and ignoring common sense, one must consider the likelihood of more government interventions that attempt to reinforce excessive risk-taking. Clearly these opposing forces will create a highly uncertain and volatile environment with continued difficulty for most investors. If continued stimulus measures do not create real sustainable growth (the last such measure was almost $1 trillion with questionable results), these political figures could bankrupt the country. This is not to say certain things shouldn't be done to combat deflation; but given the chances that capital will not be allocated productively, it is hard to envision how new stimulus measures will be successful long term. To quote Ken Rogoff in a recent Financial Times article, "a panicked government fiscal surge is far more likely to destabilize the nascent recovery than to nurture it." While austerity, taxes, and slow growth may be unappealing and painful politically, isn't it less painful than default?
We strive for our thinking to focus on realities, not hopes. We tend to highlight the potential difficult outcomes, not the rosy ones. That being said, the Fund is not in a bearish or net short position. Regardless of additional stimulative measures that could potentially drive assets prices higher short term, we are comfortable maintaining a conservative, hedged position, especially given the market's liquidity illusion. Our largest allocations continue to be with managers who do not rely solely on directional moves in asset prices and who identify attractive arbitrage opportunities. We will continue to remain patient, looking for better opportunities (prices vs. expectations) to take on risk, which may or may not be in the near future. Investors who continue to be heavily exposed to risk assets or chase short-term performance are likely to experience uncomfortable volatility and the potential for permanent losses to their wealth.
Jay Compson
Principal & Portfolio Manager
Absolute Investment Advisers LLC
(c) Absolute Advisors
