Navarro's Big Economic Picture
A Short Term Trading Opportunity

The economic stars now appear to be aligned for a possible short term summer rally.  At a minimum, the risk has shifted more to the short than the long side.  The reason: the economy is slowing down but not yet enough to affect corporate profits in the short run while inflation is downshifting as well, which argues for an end to the Fed’s current rate hike cycle.

The Fed saw this rather clearly last Thursday when it decided to go just for another 25 basis points – refusing to hop on to the “one big one and done” 50 basis point bandwagon.  This puts another rate hike on hold for at least two months because the next FOMC meeting isn’t until August.  The stock market correctly interpreted the Fed’s action as appropriately measured and had one of its best days in years.

What exists now is at least a glimmer of hope for the proverbial “soft landing” in which the economy will settle in to a slower, more sustainable rate of growth of around 3%, with inflation moderating.   I personally would not place any longer term bets that this hope will become reality.   With the ECRI weekly leading index now projecting quasi-recessionary growth of only 1.5% annually in the GDP and the housing market continuing to slide into the tank, darker days for the market are likely ahead – if for no other reason than at some point earnings are going to disappoint mightily in a sluggish economy.

Still, in the short run, traders may well be able to make a few bucks now on the long side.  That forecast will hold until there is any new and credible evidence of over-exuberant inflationary pressures.

This Week's Market Movers - A Busy Unbusy Week

With the markets closed on Tuesday and a long weekend wiping out Monday, this will be an unbusy market in the face of a very busy report week.  Chip billings, auto sales, construction spending, and my favorite supply side indicator the ISM index fly on Monday.  Wednesday it’s factory orders and Friday, it’s the all important jobs report.   That’s the likely big market mover – the jobs report.  I’m looking for a continued weakening, which the both the stock and bond markets will likely like as another sign of moderating inflation.

Portfolio Shorts and Pans - Epix and Vita

Both of my biotech holdings, EPIX and VITA, had very nice weeks.  What I have liked about the technical action has been a pattern of a steady fall in their share prices on low volume.  Then, a nice thrust upwards on high volume.  I’ll nurse these two holdings while I continue to hunt now for a few more long prospects.

Davio's Hedging Your Bets
Maximum Pain

I always like to say that the markets will do what causes the most players the most pain. This was as evident as ever going into the latest FOMC meeting on 6-29-06. Most fast money/hedge funds were under positioned on the long side and the small investor/retail was as heavily short as they have been in years.  This portended a big snapper of a rally even before the erstwhile “Hawkish” Fed’s .25% rate hike.  The Fed’s actions set the pain trap in motion and the max pain scenario played out nicely as the market rallied in a monster way last week.

Now let’s look at what is the next possible maximum pain trade. I want to relate to a few simple areas, SPX, Gold, and Oil. I think the Fed will now shift from their supposed “hawkish” stance in inflation and move to a dovish stance and will actually be fighters of Deflation. That is what the Fed fears the most, and therefore their hawkish stance is very short term in nature as they want assets to inflate as deflation is the Fed’s true big Fear!!

The SPX ran past its 200 day moving average (DMA) @ 1262 and hit the 50 DMA @ 1276 on Friday before selling off a little intraday. The next key levels are 1295 which is the 70% retracement of the entire SPX sell off from May 10^th @ 1327 to the bottom in Mid June of 1219.

If the SPX can close over the 1295 in the near future, I expect to see new marginal highs on the SPX. Our work projects that if that line is overtaken we could see a run up to 1360 to 1400 before the next leg of the bear gets to work. Why is that? That would be max pain for all the new bears that are pressing their bets. I also think that if we got to the new highs, you would get new bulls and all bears pressing their bets to the upside. I don’t think that rally would last too much higher than the 1360-1400 area, but it would be none the less painful for the bears and then when that new high is in place, the bulls will be full bore and ready to take their max pain. To me this all hinges on whether we take out the 1295 SPX range.

Gold and Oil on the other hand are making big moves again. Much bigger moves than the SPX. So the market is telling us that inflation is still there regardless of what the Fed tells  us. Gold hit $616 an oz last week after getting down to the 550 range. Gold is now back up over 11% off its latest lows. However, for Gold to break the new highs of 736 an oz. I believe the key line now is drawn around 684 an oz. If gold can get back over that level, I would expect new highs on the Yellow Metal. That is the 70% retrace of the move on Gold from  highs of 736 down to its lows of 560.

As far as Oil, it has broken out of its recent downtrend again and looks headed to new highs once again.  Oil is pushing 74 a barrel as I write today and as long as it holds the 70-71 range on the breakout I think it can be bought.  Oil is up nearly 7.5% off its recent bottoms.

So we have the SPX running up (4.5%), but not nearly to the levels of Oil and Gold. So what is it the Fed is fighting? Inflation or Deflation.

I contend that the Gold and Oil markets are the leaders and are showing us that inflation is in charge for the time being and that Helicopter Ben wants inflation in reality over deflation. So be careful what you wish for and fight against Ben, as the markets will work themselves out and the max pain trade will always win out. To me, that trade states that a possible higher equity index highs may be seen into the end of 06, but if those are achieved the max pain trade to me due to the headwinds in oil and commodities will drive the deflation that the Fed fears.  What is your maximum pain trade?

Vaino's Biotech Corner
Short Metabasis (MBRX)

I’ve been stuck trying to find a biotech stock I like this week.  Neurocrine (NBIX) has gone from bad to worse, and has destroyed almost two billion dollars of market cap in the past two months.  I still believe NBIX will get back to the $25–30 range, but it won’t be anytime soon.

Anadys pharmaceuticals (ANDS) saw its stock price cut in half on the announcement they were suspending a Phase I clinical trial of their lead HCV drug.  The announcement two weeks prior that their CEO was resigning, which may or may not be related, didn’t help investor confidence.  ANDS was trading above $15 back in April, and closed mid-week below $4.  Oddly, it was an examination of preclinical data that lead them to suspend the clinical trial.  They did the right thing by stopping the study, but I can’t help but wonder why this preclinical data hadn’t been analyzed pre-clinical trial.  You really do have to be careful in biotech.

After suggesting that Sangamo (SGMO) was overpriced a few weeks ago, I bit the bullet and shorted this illiquid biotech.  I’ve lost my aversion to shorting this type of stock. The stock went from a high of $7.95 on June 5^th to $6.03 last Wednesday (June 28).  SGMO was showing strong technical signs, but just didn’t have the pipeline to back it up.

As an occupational hazard, I usually end up thinking of most things in terms of chemistry and physics. For this reason, I would never invite more than three chemists to any social event:  they make economists seem fascinating by comparison.

To me, technical analysis is kinetics (the rate at which reactions occur) and fundamental analysis is thermodynamics (the driving force behind reactions).  The comparison between science and stocks isn’t perfect. In theory, the technical attributes of a stock are composed of all the information (including fundamentals) about the issue.  Trouble is, having all the information is very different from understanding all the information.  I’ll stop here before going on about “apparent equilibrium constants”, but suffice it to say kinetics without thermodynamic backing isn’t going anywhere for long.

Okay, so now I’ll get to the stock pick at hand: Metabasis Therapeutics (MBRX) has gone from $2.45 in May 2005 to close to $9 last week.  The stock is showing strong technical signs.  That is, kinetically, it looks favorable.

Metabasis has 95 employees.  Of these, eight are vice president or higher.  If we conservatively assume one director per executive, then almost one employee in five is a manager.  I don’t believe this is efficient.  This is entirely anecdotal, but I think over-managed small biotech companies are a recipe for disaster.

Anadys has 92 employees and at least 8 VPs.  Sangamo has 62 employees and, coincidentally, eight VPs or above.   Viropharma (VPHM) whose stock plunged from over $20 in February to below $9 has five VPs and above for 48 employees.  I would never suggest management is a bad thing (there’s a reason I have an MBA) but too much management is a burden on cash flow and can result in inertia.

It would be foolish to suggest shorting a company based solely on the number of VPs.  MBRX has been around since 1997.  Their two most advanced clinical candidates, pradefovir (partnered with Valeant Pharmaceuticals) and CS-917 (partnered with Daiichi Sankyo) are, respectively, meant to treat hepatitis B and diabetes.  In addition to these two compounds, they also have a Phase I/II clinical trial underway on a liver cancer therapy (MB07133) and a clinical trial on a potential treatment for diabetes (MB07803).  The MB07133 clinical trial has been ongoing since September 2003.  I was unable to find any press release on the status of this clinical trial.  After two and a half years this makes me very suspicious.

Metabasis was notified by partner Daiichi Sankyo that serious adverse effects due to excessive levels of lactic acid had occurred in two patients in a Phase I clinical study of CS-917.  Excessive level of lactic acid had previously been noted in preclinical studies.  Three previous clinical trials of CS-917 have already been discontinued due to serious adverse events.

Metabasis’ core technology, treatment of liver disease, is clever – it relies on activation of prodrugs in the liver by elevated levels of the enzyme cytochrome P-450.  However, it’s not novel:  the drug cyclophosphamide works the same way and has been around for decades.

Metabasis’ financials are strong enough to see them through a couple of years.  Based on clinical problems CS-917 is risky, and the lack of any information about MB07133 troubles me.  Even if CS-917 does make it past Phase III, the diabetes market is going to get very crowded in the next six months, with new drugs by Novodisk, Novartis, and Merck expected.  My play will be to wait and see if the technical strength of MBRX pushes the stock up a bit more and then open a short position.

“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

CONTACT INFORMATION
Peter Navarro
Irvine, California USA
Email  |  Website

DISCLAIMER: This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever. Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.