Navarro's Big Economic Picture
We Now Know the Answer

Well, it looks like we now know the answer to the question: Does a bull market rally in August on light volume portend a continued bull market in the historically worst month of the stock market year – September.  Apparently not as this last week was a lot uglier than the modest declines in all major U.S. stock market averages would suggest. At this point, I don’t expect September to do anything but confirm its bearish reputation.

This Week's Market Movers

Last week, I was right on the money with my market mover prediction as productivity came in low and inflation a bit hot and helped caused an ugly gap down when the market opened last Wednesday.

This week is a fairly busy one for market movers, with Monday marking the five-year anniversary of 9/11.  Expect the markets to be jittery as milestones and holidays tend to be dates in which terrorist plots are often hatched around.

Tuesday, the trade report will once again show a trade deficit of over $60 billion – and a continued increasing gap in the trade balance with China. Expect this to cause pressure on the dollar – but the recent moderation in oil prices will help a bit down the road.

Look for further weakening of the consumer, as indicated by Thursday’s retail sales and Friday’s consumer sentiment.  We also get one of those rare events where the consumer price index flies on Friday but the Producer Price Index doesn’t fly until the following week.  Any sign of persistent inflation will be a market downer.

Portfolio Shorts and Longs

Last week was a classic reason why it is important to cut one’s losses early. The best looking stock in my portfolio from both a fundamental and technical perspective, ABAX, went into the dumper, falling close to ten percent in two days. ABAX’s technicals are now nothing to brag about; and I cut back my position to a small holding and will dump that small holding if it breaches $22. However, this is a stock I will keep on my watch list -- but won’t even think about reloading until it settles down. I also pared back on HTI on a Friday reversal and remain sitting tight but unimpressed with either AXCA or STEM at this point. Basically, then, I’m close to flat; and I’m going to spend the next week or so look more systematically at the top and bottom performers in strong and weak sectors while September works through its usual rot.

Vaino's Biotech Corner
Ligand's Fire Sale

Ligand Pharmaceuticals (LGND) is one of the oldest San Diego Biotech companies.  The term “ligand’ is used in chemistry to describe molecules that bind, or hold on, to other molecules. From recent events, I’m wondering if Ligand is in a real bind and planning on letting go.

In fact, Ligand has had a bit of a stormy history. A few years ago they got into trouble with investors for stating that they expected to become profitable “next  year”.  They did this twice.  According to their 10Ks they have never been profitable. Their best year was 2002 when they “only” lost $32.6M.

Ligand has also had some accounting “issues”. They have only recently been relisted on the NASDAQ after having to restate past financial statements to do with revenue recognition irregularities.  Last month, their CEO resigned “to pursue other opportunities”. I’ve never understood why boards can’t come right out and say “he was fired”.

Last week, Ligand announced they had sold rights to their pain treatment Avinza (a slow release form of morphine developed by Elan) to King Pharmaceuticals. Ligand will receive $313M in cash plus royalties.  Under the terms of the agreement, which still has to be approved by shareholders, Ligand will receive a 15% royalty on Avinza sales for twenty months. They will continue to receive royalties on a sliding scale until 2017.  If annual sales are less than $200M they will receive a 5% royalty. According to LGND’s latest 10K, sales for Avinza were $16M in 2003, $69M in 2004, and $113M in 2005.

As part of the press release announcing the sale, they stated that they “are evaluating a distribution of a majority of the cash proceeds from this and any future asset sales (which are expected to be shielded by our remaining tax loss carry forwards) to shareholders in the form of a special dividend.”

Thursday night Ligand issued a press release that they had sold the rights to their oncology products to Eisai for $205M. Interesting. The company has now sold the rights to all of their products that generate revenue.  In March 2006, according to their latest 10Q, Ligand covered 67 of their “key employees” with employee retention agreements. Hmm….

Ligand’s stated objective is to “become a dynamic and highly-specialized R&D and royalty company”.  I thought that’s what they were trying to become before they sold off their revenue streams.  It’s not as though they have an impressive pipeline or a track record of creating great drugs, and their projected royalty stream is weak.      In a December 2005 article in Mergers & Acquisitions Report  it was reported that the hedge fund Third Point LLC had been pressuring Ligand to sell itself.  Indeed, Ligand retained the investment bank UBS as financial advisors.

Ligand has been around since 1987 and has yet to turn itself into a profitable company. My take is their current investors realize this and want their money back.  Ligand has scheduled a conference call for 11 am (EDT) on Monday the 11^th.  A big dividend will mean a drop in the stock price (ex dividend), and an increase in put prices.  This is a highly speculative play, but I think Feb 07 puts might be a good buy.

Special Feature: Vaino Looks at the Markets

Conventional logic holds that biotech and pharmaceutical stocks, whose performance is more closely tied to results—how well they are able to advance drugs through clinical trials—are a safe defensive position in a declining market.  We’ve all seen figures showing investment in the healthcare sector is a safe bet as we move into a bear market.

So, as I watched many of my favorite stocks tumble over the past couple of days I wondered how closely biotech and pharmaceutical stocks are tied to the market cycle. To quantify what relationship, if any, exists, I downloaded weekly stock prices (adjusted for dividends and splits) for the past five years for some ETFs representing different sectors of the economy.

Representing biotech and big Pharma, I used the ETFs BBH, IBB, and PPH. To compare with other sectors I looked at prices for the following ETFs: XLE (Energy Select Sector SPDR), HHH (Internet HOLDRs), OIH (Oil Services HOLDRs), RTH (Retail HOLDRs), UTH (Utilities HOLDRs), IYC (iShares Dow Jones US Consumer Services), and IYK (iShares Dow Jones US Cons Goods). I used stock prices dating back to February 2001 (note, prices for RTH were only available since May 2001).

I looked at the correlation coefficients (r²) of each ETF’s weekly percent changes compared to the S&P 500.  Correlation coefficients provide a measure of the linearity of a given relationship. That is, it quantifies how much the ETF’s price moves with respect to the movement of the market as a whole. The data are presented in the accompanying table.

A higher correlation coefficient indicates that the two variables move closer to linearity with respect to each other.  To be clear, we’re not observing natural phenomena here (I save that for my day job). I wouldn’t ascribe too much precision to the numbers themselves, I was only interested in the general trend. That OIH, the oil services ETF, has the worst correlation with the S&P is consistent with the historic inverse relationship between oil and stock prices. Similarly, the low correlation with UTH, the utilities ETF, also demonstrates that this sector is little affected by market swings. The greater correlation between the S&P and HHH, the internet ETF, is consistent with technology stocks being subject to market swings, as is the high correlation between RTH, the retail sector ETF, and the S&P.

From the trend it is evident that BBH, IBB, and PPH are all relatively sensitive to market swings, despite the idea that their performance ought to be driven more by results. That IBB, which is composed of smaller and more speculative stocks than BBH or PPH, is more closely correlated to the Market is interesting.

My point it all this? It’s becoming clear to me that for the next few months better returns will be had on the short side, and I will spend more time looking for companies whose stocks have risen too high.

“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.