Navarro's Big Economic Picture
(Bill) Gross'ed Out

I’d like to reflect this week on a couple of stories that caught my eye the last week or so – each of which gives us a different, but interesting, take on where the economy and markets might be heading. As a reference point, let’s start with the observation that the brief August rally we had bit the dust last week – and likely was more of a short squeeze rally as opined in last week’s missive. Now for the stories.

The first story appeared in the Wall Street Journal and pretty much wrote the obituary on Bill Gross as a credible prognosticator. Gross is, of course, Pimco’s bond king and oft-quoted market pundit. Seems like its been almost four years now that Gross has been getting the markets’ direction wrong, he’s not sleeping at night or eating well, and, most importantly, his investors  have been taking a pretty good haircut.

I can see how Gross has gotten into so much trouble. For several years now, the bad economic news has been mounting; and a reasonable speculator like Gross could easily jump to the conclusion that the bear is nigh.  His own problems started in September of 2002 when he projected a value of 4,000 for the Dow. That was pretty radical at the time; and anybody who had jumped on that advice on the short side, would have lost his shirt. The question is how an ultra-brain like Gross can get everything so wrong – particularly the bond market which he has hitherto owned.

One answer appears in the second story that caught my eye. Seems like most of the profits that U.S. corporations are raking in these days are going to stock buybacks. There’s no more efficient way to keep stock prices propped up than that – particularly since the flood of money is now more than offsetting all the new stock options these companies are awarding.

The third story of interest has to do with how consumers are – finally! – responding to higher gas prices, higher rates on their adjustable rate mortgages, and the declining use of home refinancing to serve as an ATM.  Consumers are cutting back – oh duh – on at least some of their consumer spending – and the retailing sector is taking a hit. That story confirms the insight that oil price shocks and rate hikes are contractionary – but again, Gross’s timing has been wrong.  Call in premature Bearitis.

I think that Gross is eventually going to be right about the stock market bear – a sustained oil price shock, a long term budget deficit, a non coincidentally weakening dollar bringing inflation, the loss of U.S. manufacturing jobs and declining per capita income, and a thousand other unkind economic cuts are taking their toll on Goliath. Still, yet a fourth story that caught my eye made me start thinking about domestic stock markets – whether in Germany, the U.S. or elsewhere – in a different way.

This story focused on how the German stock market was outperforming the domestic economy by leaps and bounds. The reason: a lot of German companies are conducting operations – both production and sales and distribution – outside the Fatherland. So even as Germans cry in their beer over a stagnant economy and high unemployment, the shareholders in German companies – from Riyadh to Toronto -- are toasting their good fortune.

The broader point here – and I think it may be at least semi-profound – is that we can no longer view domestic stock markets as leading indicators of domestic economies.  Instead, we as forecasters must look at the whole web of exchanges around the world and parse their effects region by region and country by country.  This is a whole lot harder than it used to be – which is why folks like Gross uncharacteristically have been losing their way.

This Week's Market Movers - Visions of GDP Revisions

While a lot of big players will be heading for the beaches this week, there will be some interesting reports vying for investor attention. We get a double dose of consumer confidence – The Conference Board’s on Monday and U-Mich’s on Friday. Both should signal a gloomier consumer – so any upside surprise would be bullish. My big market mover of the week bet is on the revision to 2^nd quarter GDP. There’s talk that it will be ratcheted up to over 3%, which would be bearish as it signals more inflation than previously thought.

Portfolio Shorts and Longs

Let’s start with my poodle (i.e., small dog) of the summer – the Brazilian exchange-traded fund EWZ. I bought in at $40ish, scale in a bit more at $41ish and last week lost a couple of points in a Brazilian downdraft and cut my losses quick. Licking my wounds, I sought answers. Here’s two: First, the Brazilian economy has been lifted on a sea of commodity price hikes – from soybeans to metals – and those markets may be softening. Second, Brazilian elections are soon and the Socialist leader Lulu, who looked to be in big trouble just months ago, is now pulling away with the race – putting Brazilian entrepreneurs in a deep funk.

Now let’s turn to EPIXD. This was my hot August stock – right out of Vaino’s biotech corner. Well, last week, the technicals turned South. I promptly cut my position by 75% and took some nice gains off the table. If the stock breaks through the $7 support level, I will take the rest of it off the table – but keep it high on my watch list for a reload.

Meanwhile, I’m sitting tight on three biotechs – ABAX, AXCA, and HTI. Plus, my big buys of the week were two of my favorite stem cell plays – ASTM and STEM. Both seem stable at the low end of their ranges so downside risk is minimal. With the Republicans getting beat up on their opposition to stem cell research, the political tide should soon turn. And there has been some nice good news on the science front. These are, however, long term plays.

Vaino's Biotech Corner
It's Good to Have Options

Hollis-Eden Pharmaceuticals (HEPH) has been around since 1992. Their chart looks like it would be at home on Coney Island: a definite rollercoaster.  o be clear, I would never suggest owning HEPH stock. For a company that’s been around almost fifteen years, they have little to show for it.

Their lead compound is called Neumune. It prevents loss of white blood cells (neutropenia), loss of platelets (thrombocytopenia), and loss of red blood cells (anemia). This drug has been demonstrated safe in several Phase 1 clinical trials.  The biggest indication for Neumune is protection against acute radiation syndrome (ARS).  Having ARS as an indication makes for interesting clinical development as it isn’t possible to evaluate the drug’s efficacy in humans (it would require exposing humans to unsafe levels of radiation). In cases like these, the FDA permits data to be obtained from other animals such as monkeys.  In studies with monkeys, the drug was shown to decrease some of the damaging symptoms of ARS.  hey have also completed a Phase 2 trial on another drug, Immunitin, to treat infectious diseases such as HIV and malaria. According to their website, no further clinical trials are underway to advance this drug.

Now, here’s what I think is interesting. HEPH announced in late July that the US Department of Health and Human Services is considering stockpiling Neumune (as part of Project BioShield) to prevent ARS. The stock is up 65% since then.

Hollis-Eden has a weak pipeline and a weak balance sheet. As I see it, this procurement is the company’s only hope. I have no insight as to which way the decision will go. Expect any decision to be as much politics as science. If the U.S. government decides to stockpile the drug, the price will jump: if they decide not to, the stock will crash. Buying stock in such a company is more like a trip to Vegas (minus the free drinks) than an investment.

So what options are left to biotech investors? Well, options!  Straddles, that is. To wit, simultaneously buying both a call and a put at the same strike price results in a position that makes money as long as there is a big move in the stock, as there will be in this case.

Here’s a sticking point. One of the characteristics of options is their value decays exponentially as expiration approaches. So, using September options results in a more favorable position than using October options. But, according to the Associated Press, a decision is expected BY September 15; according to MarketWatch, September 15 is the ESTIMATED date of the award. As September options expire the next day, this is critical. The Government’s fiscal year ends September 30, I assume this means any award will be made by then.

I think a straddle with a $7.5 strike is worth buying. September 7.5 calls are selling for $0.75 and puts for $1.40.  Now, to be clear, open interest on the puts is low which could be a problem. Open interest on $5 puts is pretty high, but a straddle at $5 doesn’t look good to me—not a lot of payoff on the downside. The 7.5 straddle pays off as long as the stock moves out of the $5.35 to $9.65 range. Using October options reduces the risk about the timing of the award. The same position with October options is profitable if the stock moves out of the $4.70 to $10.30 range.  The ranges will narrow as we get closer to the respective expiration dates, and I will be keeping an eye on this.

Beware, dealing in options can be much riskier buying stock and is not for the faint of heart.

“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
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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.