Navarro's Big Economic Picture
Mortgage Bear Hug

Last week, my speculation was that the bulls would run – and run they did.  All three major U.S. averages rose more than a percent while the Dow closed at record highs. The only bummer of the week can on Friday as the jobs report – my big market mover prediction for last week – came in soft as a ripe mango and put a bit of doubt in the bulls’ minds.

I remain bullish in the short term until proven otherwise, mindful that bullish falling inflation and oil and commodity prices are competing with bearish slowing growth for the hearts and minds of the market. But at this time of year, risk-to-reward favors the long side.

That said, let’s look at two things – one short term and one long term – that could maul the bulls. Short term, and as my big market mover of the week, there is the beginning of earnings season. Those who follow this column know well that it will not be how much the corporations have earned but rather what their guidance will be. Any pattern of lowered guidance that begins to emerge will be very bearish.

Longer term, I’d like to relate a conversation I had with a buddy who makes his living selling mortgages to the “Joe Sixpack” heart of America – his words, not mind. He’s on the phone 12 hours a day, hawking his wares all over the country so he’s a pretty good pulse on Americana. What he told me was a bit bone-chilling.

First, with the fall in housing prices, more and more people are hitting zero or negative equity in their homes.  If rates rise further, more and more of these folks will walk away from their over-leveraged castles.

Second, and here’s the scary part, a lot of people now find themselves trapped in adjustable rate mortgages, unable to refinance.  The reason is diabolical.  With the fall in housing prices, they no longer have the equity and loan-to-value ratio to qualify for a new mortgage.   So they are stuck in the ARMS of the bond market, and if interest rates do take off, these folks are going to take the worst whupping of their financial lives.

Lastly, the house as an ATM trend continues. But, my friend tells me, people are taking out smaller and smaller amounts because that’s all the equity that is left. Desperate to get cash to fuel their fantasies – or simply feed their families – these folks are likewise nearing the end of the dangerous rope.

This Week's Market Movers

Besides earnings data, there’s not a lot of economic reports likely to move the markets.  Monday will be exceptionally quiet as Columbus Day shuts down the bond market.  Thursday could provide some sparks with the trade data while retail sales come in on Friday.

Portfolio Shorts and Longs

My stock of the week is FortuNet (FNET). It’s a weird wireless gaming play. Basically, the company makes wireless gaming machines for casinos, and the company was recently granted a license to operate in Nevada.  The stock is a recent IPO and its price took a hit last month on lowered guidance, but its technicals are very strong and the potential market seems vast. Bon chance!

Vaino's Biotech Corner
The Future of Avanir

Readers conversant in French will, hopefully, appreciate the pun in the title. Avanir Pharmaceuticals (AVNR) started out as Lidak pharmaceuticals in 1988 and, unlike most biotechs, has an over-the-counter medication (Abreva for treatment of cold sores, rights to which were sold to GSK). Aside from Abreva, they’ve had almost two decades of frustration.

For a while Avanir was developing vaccines against cancer, but that didn’t quite work out. They tried antibodies to treat asthma, but they didn’t really pan out either, so they looked to cough syrup. Yes, cough syrup.

Turns out, dextromethorphan (DM) is a noncompetitive N-methyl-D-aspartate (NMDA) antagonist that has potential neuroprotective, anticonvulsant, and antinociceptive activity.  rouble is, DM is rapidly metabolized to another species (demethylated to give dextrorphan, in case anyone was wondering) that does not have neurological activity. Avanir’s approach is to coadminister the drug with another drug, quinidine, that is known to inhibit this demethylation. A 2004 study in The Journal of Clinical Pharmacology showed that quinidine inhibited DM metabolism. They call the combination of these two ingredients Neurodex.

In 2001 Avanir started a Phase 2/3 clinical trial on the use of Neurodex to treat emotional liability for patients suffering from ALS (Lou Gehrig’s disease).  About 10-15% of ALS patients (according to the ALS Association about 30,000 Americans have ALS) suffer from this condition, also known as Pseudobulbar syndrome:  it’s not a big market. The phase 2/3 study did show that Neurodex was statistically superior to either DM or quinidine alone.  In late 2002 a Phase 3 study was initiated. The results were published in a 2004 paper in the journal Neurology and a 2006 paper in Annals of Neurology, and indeed the drug seemed to effectively treat Pseudobulbar syndrome. The drug is not without side effects (25% of patients discontinued the study in the first month) and was the subject of a commentary in the journal Neurology. In addition, a 2005 paper in Lancet Neurology also expressed concern about side effects of Neurodex.

In June 2005 Avanir submitted an NDA for Neurodex to the FDA. Also in June 2005, a phase 3 study examining the application of Neurodex to diabetic neuropathetic pain was initiated. This trial is expected to be completed in 2007.

The FDA asked for more data on Neurodex, and this was completed in January 2006. In April the company announced that the FDA was expected to take action by July 30. In June, the FDA decided it needed more time, and a decision has been put off until October 30, the day before Halloween: talk about a witching hour for Avanir.

It’s impossible to gauge exactly how the FDA will rule on Neurodex. My guess is the combination of doubt cast on Neurodex in the neurology literature, combined with the FDA first asking for more information and then saying it needed more time to reach a decision means the drug will not be approved. Avanir has weak balance sheet and, based on their burn rate, will have to raise additional capital within the year. This may or may not be before the results of their other phase 3 clinical trial are released.

I think a straddle with November options is a good move. Given the decay of time value of options (theta) there’s no advantage (and, in fact, a disadvantage) to opening this position early. I’d wait until the 29^th of October to open a straddle. But here’s a twist. The FDA is pretty good at providing its decisions when it says it will.  One way to tell whether the decision is negative will be if there is no press release by the company that the drug has been approved.  No press release early in the day often, but not always, a sign the drug has not been approved.  Now, the stock will move regardless of whether the decision is positive or negative. But, a bonus play will be to wait until 2 or 3 in the afternoon on October 30^th. If Avanir has not released a press release by then, you can be pretty certain the drug has not been approved and the stock will tank. Given AVNR’s history, it will tank hard.

“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.