The three stages of the current stress pattern.....

Louis Gargour, one of LNG’s two principals, and manager of the LNG Special Situations Fund, explains why we are currently in the first stage of a three-stage cycle.

From the monitoring of credit cycle dynamics, LNG identifies stressed debt, and believes that banking leverage will become more greatly restricted as the year progresses, that this will lead to rising bankruptcy levels and the emergence of highly lucrative distressed debt opportunities. The manager continues to maintain a cautious approach as history tells that bear markets can and do have multiple sharp rallies.

Distressed is becoming interesting
Louis Gargour is currently seeing an increase in client inquiry in distressed (debt and equity) in the special situations fund. This asset class is beginning to produce interesting opportunities as a result of market distortions and overleveraged balance sheets.

He has been running similar strategies for a long time and has been in this sort of situation in the last market cycle (he made a lot of money in 2003.) He found that the stress pattern has three stages. Here is how he described them to Opalesque.

1. Macro-economic downturn
“The first stage (which we are currently in) is where macro-economic outlook is negative,” he said. “Expectations of consumer spending patterns makes us think retailing, consumer discretionary, automobiles, luxury goods, hotels, airlines are sectors that are going to suffer. I think most of the market shares in that view. I would call this particular stage of the cycle ‘stressed’ (as opposed to ‘distressed’). We are now seeing the market revaluing equity prices significantly downwards in the expectation that earnings and especially margins are under pressure.”

Since we are now at stage 1 and near stage 2, what needs to be done is to maintain a short to neutral exposure to the market.

2. Increased borrowing costs and decreased margins
“The second stage of the distressed cycle is where lending doesn’t exist. Banks will not refinance and so will not let companies who have lower credit ratings borrow money at any cost.”

“We have a market neutral approach so we care about whether a short goes down or a long goes up relative to them. That is stage 2 trade.”

3. Capitulation and default
“The third stage is when companies decide to restructure their balance sheet – which might mean file for bankruptcy. Most companies think bankruptcy is forced upon companies; that is not true. In the 2001-2002 credit cycles, a number of large telecom companies in Europe......................

Source:
http://www.opalesque.com/AMB2008/46102The_three_stages_of_the_current_stress.html


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