INFERNO, SECTOR ROTATIONS,
& BERNANKE'S SEMI-BOUNCE
The Well-Timed Strategy for Week Ending May 5
by Peter Navarro, Ph.D.
with Matt Davio & Andrew Vaino
April 30, 2006
Big Economic Picture
Well, so far we know that the new Fed Chairman Ben Bernanke is at least translucent, if not transparent. His performance last Thursday before Congress was very much unlike the typically opaque and inscrutable Greenspan. In his testimony, Bernanke suggested that the Fed might build some pausing into its interest rate hike routines, and the stock market soared, at least for a day. By Friday, of course, it was back to some bearish business and the indices closed near the flat line for the week, with the NASDAQ slightly down on Microsoft�s stumble.
It�s nice to know that Bernanke is a bit more flexible that Sir Alan, but it does make shorting this market a bit more risky. After all, if you can�t trust the Fed to go too far with its tightening and cause a recession, who can you trust?
The other news that caught my eye last week was an announcement by the Chinese central bank that it was raising rates to cool down its overheating economy. Unfortunately, it�s the wrong solution. The real problem now is that China is overheating from an undervalued yuan. It�s not just that it guns the export engine. To keep the yuan low, China must continually print domestic currency that it can then trade for dollars and euros and yen as it pours in through Foreign Direct Investment. Push will come to shove at some point -- unless the yuan is properly valued.
This Week's Market Movers - In Like a Lion with the Big Kahuna
The month of May will come in like a lion with reports on auto sales, construction spending, and the ISM index on Monday and the Big Kahuna jobs report on Friday. The risk with the ISM is to the downside as everyone expects it to be robust. I continue to marvel at the fascination with the Jobs Report as it is more of a lagging indicator. Still, it will provide some clues to Fed policy through the wage inflation component.
Portfolio Shorts and Pans - Quick Hits
Based on last week�s Andrew Vaino column, I did get in and out of some Jan 2007 calls on CELG, cashing in on the earnings news for a nice quick gain. I closed DVSA as it sunk below $10 and will wait till earnings come in before possibly reloading. I likewise closed MEDX as it is flashing short signs, but did bounce later in the week.
I�m holding AKSY, a hemodialysis play; Acacia Research (CBMX), a genetics play; Spherix (SPEX), a biotechy sweetener play, Synergetics (SURG), a glaucoma microsurgery play; SVA, the bird flu play; and Xoma (XOMA). None of them, however, are going anywhere.
I�m remain short QQQQ, although its safe to say my conviction was again sorely tested last Thursday on the Bernanke bounce. I intend to cover my XLF short next week with spreads now widening. (See Davio�s column below for further comment.)
Last take: This is one of the more difficult markets in the last five years to make a buck in either short or long. Know when to hold but know when to fold�em too.
Hedging Your Bets
This week I want to do a quick review of the largest sector ETFs that trade. The US stock market continues to grind to new highs every day, with Oil and Gold rising with interest rates. By simply looking at the sectors, we may see where and how this market is trending.
In this regard, reflation works -- until it doesn�t. So there isn�t much point in trying to short or fade this market aggressively as the trend for over 3.5 years has been strong to the upside. Nonetheless, it is Interesting to see how the US dollar continues to get hammered and how it closed down in the 86 range on Friday. What the bulls our gaining on the market, they are losing on currency risk.
Here, then, are key 9 sector ETF�s we at Red Rock Partners follow:
S&P UTILITIES SEL SEC SPDR FD
Let�s start with the utility ETF. It is moving down as interest rates rise. The cost-push associated with rising interest rates and energy costs make profits less likely for utilities. That�s why you only want to buy utilities when interest rates and/or oil prices are falling.
S&P ENERGY SEL SEC SPDR FD
Energy and Oil are in an obvious bull market here with worldwide demand far outstripping supply. As long as oil stays above the $50 per barrel range, you want to be buying the dips on this bull market sector. Oil is likely going higher, to $100 per barrel, if not $200 in the long term.
S&P FINANCIAL SEL SEC SPDR FD
Financials have gone parabolic recently, and with the spread on the short term and long term yields widening, the large market participants are piling into the financials. This is clearly exhibited by last Friday�s price action as the breakout hit all large holders radars, and this ETF has exploded.
MATERIALS SEL SEC SPDRS FD
The materials sector ETF clearly shows the worldwide explosion of demand for build out materials. Mining, processing, construction�..these are the companies you look to�Dow Chemical, Alcoa, Newmont Mining, Phelps Dodge. The bull market continues and should be bought down to $31 for the time being.
S&P INDUSTRIAL SEL SEC SPDR FD
This Industrial sector mirrors the XLB and offers a healthy bull market run for 2006.
HEALTH CARE SEL SEC SPDR FD
Health care has been on a poor run over the past year. The problems are numerous�.litigation, poor pipelines, Medicare reimbursement, you name it. J&J, Amgen, Pfizer, Merck, Abbot Labs continue to struggle. The health care sector is getting cheap, but it is still not a buy.
S&P TECHNOLOGY SEL SEC SPDR FD
Tech is not leading this market. Rather, it is the old stodgy manufacturers and service providers as is seen by the XLK chart. Most of the gains in tech came in the first week of the year and has been slightly down since hitting a peak in early January. There�s not a lot of strength here.
S&P CONSUM STAPLE SEL SEC SPDR
Consumer staples are also fairly flat for the year, which is to be expected when investors have yet to get defensive. This ETF has been range-bound since 2004, and we do not expect much direction here.
S&P CONSUM DISCRETIONARY SEL SEC SPDR
As for the consumer discretionary sector, we believe that the consumer is slowly being tapped more than they realize via higher interest rates and cost-push pressures from gas prices, etc.. Home Depot, Lowe�s, and Target have Ebay, Walt Disney, and Time Warner to hold them up, but we do not expect large growth from this sector.
As you can see from the key sectors above, we are clearly in an interest rate sensitive market where banks prosper and borrowers suffer. How much will this be pushed down to the consumer in the near future?
I believe interest rates and higher energy are a headwind for the consumer and stock markets over the longer run. However, today the charts are mainly in bullish modes as they have been for over 3 years. I am neither full out bullish or bearish at this juncture. We are at an interesting juncture in the overall picture of the markets. One that offers to us limited upside and potential higher risks as the days roll on for the downside. Protect gains as always and watch the trends of the overall markets.
Discovery Labs (DSCO) had some problems last Tuesday. On news of manufacturing issues for Surfaxin, a protein�surfactant hybrid designed to treat respiratory distress syndrome (RDS) in premature infants, DSCO went from a high of $4.77 to close at $2.20. This reminded me of Zdeno Charo, of my beloved Ottawa Senators, taking out Tampa�s Vince Lecavalier in the NHL playoffs last Tuesday night. The stock closed at $2.91 Friday.
RDS occurs in about half of babies born between 28 and 32 weeks. Incidence of RDS approaches 100% in babies born at 26 weeks or less. According to a 2004 study in the journal
Neuroendocrinology Letters, the rate of premature births is increasing. Current therapies to treat RDS are derived from animal sources, specifically, cows and pigs. These both have their own processing issues. Also, it won�t take too many more cases of mad cow disease for these to lose appeal.
In addition to Surfaxin, DSCO has three Phase 2 studies and one Phase 1 study on application of their surfactant technology to other respiratory ailments. Not a bad pipeline.
DSCO�s finances are adequate. At the end of 2005 they had $51M in cash and a burn rate of almost $60M per year. They just completed a $50M financing round which gives them some breathing room.
DSCO has orphan drug status for Surfaxin in the US, and also the equivalent from the Commission of the European Communities. This gives them near monopolistic access to the market for the next six or seven years. This isn�t a huge market. But DSCO is not a huge company, and it�s a growing market.
This isn�t the first time DSCO has had manufacturing issues with Surfaxin. In February 2005 they received an Approvable Letter from the FDA. An Approvable Letter means the FDA is ready to approve the drug subject to certain conditions. In this case, the FDA had concerns about manufacturing controls. Importantly, no further clinical studies were required. Simply put, the FDA is convinced the treatment is valuable but they wanted stricter controls on the manufacture of the drug itself. Surfaxin is a hybrid of peptides and various surfactants. These are challenging to manufacture.
DSCO�s current trouble stems from problems with drug stability. Specifically, batches set aside for stability studies did not meet specifications. I listened to DSCO�s conference call last Wednesday. They have no idea why the batches failed and are thoroughly investigating. It was pointed out that they have previously manufactured many batches without problem. All in all, this is at least an eight month setback.
Here�s where it gets interesting. Until December 2005, DSCO had been outsourcing manufacture of Surfaxin to Laureate Pharma. The batches that failed were manufactured prior to this. Last December they bought the manufacturing facilities from Laureate. From my experience with outsourcing the manufacture of pharmaceuticals, I know that even the best relationship with an outside vendor doesn�t afford the same degree of control and oversight you get internally.
DSCO has already demonstrated that Surfaxin works, and the FDA has said it is worthy of approval. My take is this: Fixing chemistry manufacturing control issues is a LOT easier than finding a treatment that works. My crystal ball isn�t any more accurate than anyone else�s. Still, I think DSCO will overcome these manufacturing problems, especially since they now have a much greater degree of control.
Therefore, I think this is a stock worth buying. At less than $3 there�s definitely more upside than downside. Of course, it�s important to realize that any biotech stock, particularly when the company has no products, is risky. I�ve noticed in a couple of other �biotech bounce back plays� (distressed biotech stocks that I thought would rebound) that the prices tended to go up a bit, retrace, and then go up for real. I�m not good enough at technical analysis to make any convincing arguments about support, resistance, or W patterns, so I’ll leave it at my, admittedly limited, observations. I’ve already opened a long position on DSCO, and will scale up on any dips in the next few weeks.
© 2006 Peter Navarro, Matt Davio, & Andrew Vaino
Matt Davio is a managing partner at the hedge fund, Red Rock Capital Fund. Catch his Daily Blog as PeterNavarro.com
Andrew Vaino is a Ph.D. chemist who spent two years at The Scripps Research Institute in La Jolla, CA, working in the laboratories of Nobel-Laureate Barry Sharpless and Kim Janda. He currently teaches at The University of Maine, where his research group is focused on exploring the interface between enzymology, organic chemistry, and nanotechnology.
“Any trader or investor who ignores the power of macroeconomics over the world’s financial markets will, sooner or later, lose more than they should and if they are trading on margin, perhaps more than they have.”-- If It’s Raining in Brazil, Buy Starbucks
Peter Navarro is a business professor at the University of California and the author of the best-selling investment book If It's Raining in Brazil, Buy Starbucks and The Well-Timed Strategy. His latest book is The Coming China Wars: Where They Will Be Fought, How They Can Be Won.