Palos Credit Fund
By Adam Smalley and Michael Culver

The high yield bond market was down about 3/8 of a point last week on very light volume. We had been expecting an fund outflow from high yield mutual funds last week – seemed like the market was better offered all week – but mutual funds managed to have $50mm in net inflows.

The Fund bought Boralex 6.75% Convertible Sub Nts ’17 last week at par in the new issue market. The use of proceeds is to fund the squeeze-out of Boralex Power Income Fund. While the initial conversion premium was high at about 60%, we see real value in the merged company. Also, if the merger doesn’t happen, we have a par put to Boralex. The Fund also benefited from takeover speculation on US Steel (the Fund owns US Steel 7.375% Sr Nts '20). A likely acquirer of US Steel would be investment grade and would cause the US Steel bonds to trade up several points.
 
With earnings season behind us and no new issue calendar this week, we expect a slow week.

Palos Income Fund
By Tommy Nguyen, Charles Marleau & Yarith Chhiv

During the past week, the fund increased its exposure in the gold sector by increasing its position in Kinross. Our traders made several pair trades: bought long Arc Energy Trust and sold short Bonavista Energy Trust; bought long Research in Motion and sold short S&P TSX 60 exchange-traded fund; bought long Encana and sold short Talisman; bought long Armtec Insfrastructure Trust and sold short Stantec; bought long Algonquin Power and sold short Fortis Inc. As for our risk arbitrage strategies, we added a new position in Bowse & Co (3% Gross Spread for a 16.8% annualized return) and we were fortunate to be long 3Par Inc., a high-end data center storage company (Dell Inc. and Hewlett-Packard Co are in a bidding war to acquire 3Par Inc.). After multiple increases in the takeover bid price, the stock price of Par3 is up 24% for the week.

Palos Capital Pool
By Mazen Haddad

Ludia Inc. A core holding of the Palos Capital Pool LP recently announced the launch of "Press Your Luck" on the Sony Play Station 3. Ludia also announced the completion of the licensing of the game show "Pyramid" for a computer game.

Risks, Hedges and Opportunities
By Hubert Marleau

Amid fresh reports of economic weakness in the housing, retail and manufacturing sectors and in the labour market, the complexion of the US economy has shifted toward the deflationist view of a long period of low inflation and low growth until the necessary deleveraging process in the private sector is over.

It is now estimated that in the five quarters ending September of 2010, Real GDP will clock in at the annual rate of 2.6% with an annual inflation rate of 1.0%. Economic recoveries are usually, albeit not always, much stronger than the current experience. During the past four months, the equity markets have been under periodic downward pressure, while bond yields have tumbled, reflecting the vulnerability of the recovery.

Leading indicators are measuring a 33% probability of a renewed recession while prices for derivative insurance suggest a 20% chance of deflation over the next few years. What is making it even more difficult for investors is the reason offered by the deflationists that another round of either monetary and/or fiscal stimulus cannot do the job because America is too indebted and the FED has run out of ammunition. These concerns are not exactly correct.

First, there is growing awareness in academic, business and government circles that in order for fiscal stimulus to have a multiplier effect on national output, it needs to be focused much more on structural problems like infrastructure, education, research, tax reforms, trade barriers, tax reform and research rather than on cyclical issues, like temporary subsidies, tax relief, cash for clunkers, housing, or hand-outs.

Second, there are monetary options available to spur a faltering recovery. The Fed could take several actions like lowering the rate of interest paid on bank reserves, using rhetoric with more precision and less conditionality, deploying moral suasion more directly, targeting a higher inflation rate and easing up on healthy banks and purchasing more monetary assets.

We believe in the statement that Mr. Bernanke made in Jackson Hole last Friday. He said that falling into deflation is not a significant risk for the US at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. However, politicians are short-sighted and unfortunately won't respond to the fundamental fiscal need of the country, for their only concerns are with the election cycle.

While we sense that the FED can arrest deflation and counter a renewed downturn in economic activity, by the same token the US economy will not enjoy a normal recovery, nor a normal growth trend, because the national agenda is too cyclically focused for fiscal policies to have a multiplier effect on national output.

Our original forecast - that the US economy in nominal terms is likely to run around 3.0% for the foreseeable future - is not changing. This may seem too close for comfort and, in turn, prudence is dictated. But bear in mind that this is not set in stone.  Reported outright declines in the level of business activity have been vastly exaggerated. To the extent that deflation and inflation are always and everywhere a monetary phenomena and not about aggregate demand, the cure to the current situation may be just that: a fall in prices. There is not much of an empirical link between deflation and recession. The media is reporting and not analysing. According to a study conducted by Andrew Atkeson (UCLA) and Patrick Kehoe (University of Minnesota) there are more periods of deflation with reasonable growth than recession and many more periods of recession with inflation than with deflation. Unfortunately, that will be insufficient to raise the pace of recovery in employment but sufficient to repair the damaged finances of the private sector.

That is why there will be a moment in the foreseeable future when investors will stop looking for preservation of capital and seek yield on capital. History shows that an investment cycle usually lasts five years. Yields are averaging 2.50% on dividend-raising stocks composing the S&P 500 Index, and that is 100 basis points more than 5-year notes and 225 basis points above 5-year Treasury inflation-protected securities. 

Since the end of WW2, dividend yields exceeded that of treasuries only during the 1950s.

We may have, right in front of our noses, a once-in-a-lifetime opportunity.

News you can use
By Robert Sands

Your friend is a lagging indicator.

While it may not be polite to call your friend a laggard, it might just be the case (from an economic standpoint).

Remember the tale of the shoeshine boy on the corner of Wall Street offering tips (not to be confused with TIPS) to clients regarding hot stocks?  Well now hot stock tips, and stocks in general, are anathema. Bonds are the flavour of the day as there is a perception that your capital is preserved.  Well in fact, your capital is preserved only if you hold an individual bond issue to its maturity, and the bond is redeemable at par.

Still, investors are running for safety.  A neighbor of my sister in Ocean City, New Jersey told me that he knew of someone selling his house, buying gold with the proceeds, and turning himself in as a ward of the State.  Has he been watching that Jersey Shore series on TV?

So if your friend is a lagging indicator, what indicator should be used to divine the current economic state of affairs?

My crystal balls of choice follow:

http://www.philadelphiafed.org/research-and-data/real-time-center/business-conditions-index/
(Hint: the ADS data is turning up.)

http://4.bp.blogspot.com/_sy2qqBjcPIg/THfR4XHp0vI/AAAAAAAAB5Y/NHaDXj_GlbQ/s1600/ECRI_WLIvsWLI_GrowthVsGDP.png
(Hint: the ECRI data is turning up)

http://2.bp.blogspot.com/_sy2qqBjcPIg/THQBVU_e5PI/AAAAAAAAB5A/jvbRovZtUZA/s1600/BTIG_Fed_Model-2010.gif
(Hint: Stocks are on sale.)

So ask your friend (after you have shown him or her the above charts) if the glass is half full or half empty. Whatever the response, a balanced, tax-efficient (maximize your TFSAs), prudent approach appears to be the order of the day.

Do you know the only thing that gives me pleasure? It's to see my dividends coming in. - John D. Rockefeller