The very tough market environment continues, but at the risk of sounding like the boy who cried: “Wolf!” there was a sign of strength today that could be the harbinger of the next upleg. Back on March 17, the S&P 500 low was 1270, although the futures got as low as 1255 before the opening. I didn’t think the S&P would need to revisit that area before starting what is shaping up to be one of the sensational rallies of all time, but it did. On June 27 the Index dropped to 1272 and bounced a bit, indicating that support level might hold. But the continuing bad (and old) news from the financial sector negated that thought, and last Thursday, before the three-day holiday, the Index touched 1252 before rallying into the close. Again, it looked like that could mark a bottom.
Then this week’s rollercoaster ride occurred. Monday saw a stab down to 1240 before bouncing right back to 1252. Tuesday saw early weakness down to 1243 followed by a 31-point rally to a 1274 close. That breakout sucked in all the bulls, including me. Good job, Mr. Market! The bull trap snapped shut yesterday in a waterfall decline back to 1245, and on to this morning’s bottom at 1237 and afternoon retest at 1239. The S&P has now declined 20% from its October high of 1576, finally entering official bear market territory.
However, after Fed Chairman Bernanke and Treasury Secretary Paulson testified this morning, the S&P bounced back in a stair-step pattern. One day does not a rally make, but regaining 1253 by the close means this could be the actual double bottom I’ve been looking for. I want to see the S&P head back down briefly to test 1244 or even 1237, and then rally back over 1270 before I finally believe that we are truly off to the races. The opportunity for the bulls is there, and we will let the market tell us what to do.
Bernanke and Paulson Encourage the Market
What did Bernanke and Paulson say in this morning’s testimony to make the market feel better?
“It is clear that some institutions, if they fail, can have a systemic impact. For market discipline to effectively constrain risk, financial institutions must be allowed to fail.”
Like Bear Stearns, right? If it had been allowed to fail, the traders and top execs would have had to return a billion dollars of bonuses to the bankruptcy court. So much for market discipline.
“We want a strong dollar. A strong dollar is in our nation’s interest. We’re going through a tough period right now.”
Yes, a tough period that’s now lasted–what–10 years? Or do you want to go back to 1971, or even 1946? And if you think this is tough, wait until you announce that the U.S. taxpayer is going to pay for the subprime mortgage mess by guaranteeing agency debt.
You may remember Secretary Paulson last year reminding the markets that the government does not guarantee Fannie and Freddie’s debt, which caused major market drops. But yesterday, Fannie Mae had a terrible debt offering, with investors treating the AAA-rated two-year paper like it was five steps lower amid rumors of insolvency. William Poole, the former head of the Federal Reserve Bank of St. Louis, retired from the Fed in March and is even more outspoken now than he was before. He said yesterday that both Fannie Mae and Freddie Mac are insolvent, and that the government should acknowledge it. Of course, if the government did that, they would have to make their implicit guarantees explicit, putting the taxpayer on the hook for billions of dollars of real estate loans.
Would they do such a stupid thing to us? In a heartbeat! The agency bonds that Fannie and Freddie issue are held by most U.S. banks as a large part of their reserves. In 1998, there were about $3.5 trillion in U.S. Treasuries outstanding, and another $3.5 trillion in mortgage-backed agency debt. Today there are about $4.5 trillion in Treasuries outstanding, but after the real estate bubble, there is $9.5 trillion in agency debt. Many banks hold this paper in similar proportions.
Yesterday, the spread between agencies and Treasuries reached a 22-year high. But the banks can only hold them if they are rated AAA, which has them dependent on the implicit guarantee. (Neither Fannie nor Freddie has filed audited financials for the last few years, yet the SEC lets the stocks trade and the rating agencies maintain their top rating.) With traders now indicating that they have lost confidence in Freddie and Fannie’s balance sheets, the rating agencies will have to downgrade the debt unless the government makes the guarantee explicit. These are the “bond vigilantes” from the 1980s back in the saddle again, administering discipline to a government that in fiscal and monetary matters shows no discipline at all. If the agency debt is downgraded, banks will have to sell it to buy Treasuries that meet the standards for capital reserves. But there’s no one to sell to. Foreigners don’t want to buy dollar-denominated debt because they know in spite of Paulson’s posturing a declining dollar solves many of his and Bernanke’s problems. Plus, a lot of their institutions already hold tons of U.S. agency debt.
The Deutsche Bank analyst, who is also a former Freddie Mac executive, stated on a conference call yesterday that Freddie Mac (FRE) could go below $5. This information was given as the stock was falling 25%. It was down another 22% today to $8.00. As soon as the run starts on agency debt, a formal guarantee could come any day, which would spark an enormous equity rally in spite of a plunge in the dollar. If oil prices start down at the same time…well, you can see why I keep saying we could see a life-changing rally out of this mess.
I said last week that a drop through 1257 on a closing basis is likely to snowball into a fall to 1210 or even 1152. That risk is still on the table, so we need to see a close over 1280 to believe the rally is starting for real. In the meantime, June quarter earnings reports start next week, and most companies should hit their numbers but give cautious guidance due to the state of the domestic economy. Even in this quiet period, we’ve had some news.
Biotech MegaShift
Affymetrix (AFFX) was sued by MIT for patent infringement related to an expansion of the GeneChip technology. The patent regulators ruled in May that MIT was the first inventor on a patent application that Affymetrix filed in September 2004, and I am sure that the two have been talking about royalties ever since. This is just part of the negotiation strategy, and I expect it to be resolved with a licensing agreement that will not damage Affymetrix’ business. Obviously, MIT is more interested in getting royalties than damaging the source of the royalties. MIT and one of its professors own a company that holds the MIT patent, and it is entirely possible that Affymetrix will just buy it. AFFX remains a buy up to $15 for my $35 target by next April.
Amgen (AMGN) sells for 11X the 2008 consensus earnings estimate, and 10X 2009. Genentech sells for 22X the 2008 estimate and 19X 2009. Celgene is valued at 42X 2008 and 27X 2009. Amgen is expected to grow earnings 10% in 2009 and 10.4% longer term (five years). Genentech is expected to grow earnings 13% next year and 21% longer term. For Celgene, the 2009 earnings growth rate is 53%, and 41% long term.
I know of no reason why Amgen should grow at half the rate of Genentech and one-fourth the rate of Celgene over the next five years, when they all have major pipelines of new drugs, the same market and the same regulatory environment. To put it another way, AMGN’s stock discounts a very modest future, where surprises are likely to be to the upside. Celgene, however, discounts a rapid-growth future, where surprises are likely to be on the downside. It made sense to bring Amgen’s stock down once to lower the current earnings base due to lower sales of Epogen and Aranesp. It does not make sense to bring it down twice to reflect a lower growth rate, unless the denosumab osteoporosis data coming soon disappoints (it won’t). Buy the Amgen January 2010 $40 LEAP (WAM AH) under $10 with a $20 target.
ViroPharma (VPHM) has a July 23 date with the FDA Pharmaceutical Science and Clinical Pharmacology Advisory Committee that will review the steps a generic-drug maker would have to go through to get approval for generics of drugs similar to Vancocin. The Committee has emphasized this is not just about Vancocin, and there will be later hearings to cover specific drugs. Although VPHM fell when the FDA floated a rule to allow generics without human testing, it has become obvious that (1) the timetable for a Vancocin generic was not altered in any way, contrary to everything Wall Street was worried about, and (2) the path to a generic version of Vancocin is going to be much tougher than the Street or the generic companies expected. In light of the misperceptions the stock still languishes. In light of this meeting, I am making VPHM a Top Buy while it is under $12 for my $25 target.
Content on Demand
EMC (EMC) was nicked for $2 a share after their 86% holding in VMware (VMW) plunged following the replacement of the founding CEO, Diane Greene. She’s done a great job building the company with her husband, Mendel Rosenblum , the company’s cofounder and Chief Technology Officer. I expect he will bail shortly. EMC replaced her with the former #3 executive at Microsoft, Paul Maritz who retired in 2000 from Microsoft after 14 years at the company and started a small company that EMC bought. He brought Windows 95 and Windows XP to market, and certainly adds the kind of senior management that Wall Street usually likes to see. But the change was so abrupt that it rattled the Street. It doesn’t help that VMware also said their revenue growth this year would be “modestly” below their 50% guidance. VMW was down about 30% after the news.
A different viewpoint on the situation is that VMW is growing almost 50% in an environment where others can’t grow at all, and they’ve now replaced the entrepreneurial management with experienced senior management to take the company to the next level. I think that’s how Wall Street will view it after the dust settles. Microsoft is VMware’s main competitor, and Maritz knows exactly how they think. It’s hard to imagine someone better able to lead the company for the next few years. Continue to buy the EMC January 2010 LEAP call with a $15 strike price (WUE AC) up to $5 for an $11 target.
Intel (INTC) will be one of the first technology companies to report earnings after the close next Tuesday. I am looking for 25 cents a share on $9.2 billion to $9.3 billion in sales, with guidance for 32 cents to 36 cents on revenues of $9.8 billion to $10.3 billion in the September quarter. While the U.S. outlook will be murky, the Asian forecast will be quite strong.
Charles P. wrote that: “The INTC JAN 2009 LEAPS are becoming a worry for those of your subscribers who purchased them. INTC stock is under pressure and the LEAP is falling at an uncomfortable rate in sympathy. On top of this we have the time erosion factor. With all this going on the LEAP continues to stay on your TOP BUYS list. Please Michael; give us some comment on why you see this LEAP surviving.”
Charles, I understand your worry, as we are entering the period where time premium starts to disappear and the stock needs to move up quickly to hit my targets. Wall Street seems to think Intel is a big, inflexible company that can’t adapt quickly. Obviously, I think Wall Street is wrong. Intel’s CEO, Paul Otellini, has done a great job of revitalizing the product line while reducing costs, and I think some amazing things are coming in several areas: Pushing the X86 architecture into very low-power devices, integrating WiMAX and other broadband access protocols into the processor, as well as introducing phase-change memory. But the big driver short-term is when people get comfortable with the economy and stage a major stock market rally. Intel is viewed as a cyclical stock, and even with lingering problems (however well contained) in the financial sector, technology is the likely leader of the next upleg. When the institutions want more technology, Intel is one of the first stocks they buy.
An interesting insight into Intel’s reach: The FDA just passed Intel’s home-health care tools to enter human trials. The Intel Health Guide is a set of tools in a dedicated touchscreen computer.
The computer attaches to typical home healthcare devices like blood pressure monitors, glucose meters and scales. It then collects data and sends it via the Internet to doctors for monitoring. Intel thinks they can save the healthcare system a bundle by providing a system that lets people care for themselves at home in an effective, monitored way. They are targeting the diseases of aging in anticipation of the baby boomers’ age wave. This is just one example of the flexible, innovative company we own, and unless there is no rally, I still think the LEAPs will pay off. The Intel January 2009 LEAP (NQAX) calls with a $22.50 strike price remains a Top Buy under $6 for my target price of $12.50 when the stock hits $35 before expiration.
Telkonet (TKO) said they have installed their 200,000 wired hotel room, providing broadband access over the electrical power line (BPL). While they have an amazing opportunity to sell their energy management systems in this high energy cost environment, the original core BPL business is humming along. They are now in Choice Hotels, Destination Hotels & Resorts, Marcus Hotels & Resorts, AmericInns and Vantage Hospitality, among many others. TKO remains a Top Buy up to $5 (yes, almost 10X the current price) for my $15 target.
New Energy Technology MegaShift
Gasco Energy (GSX) said they had record gas production in the June quarter, hitting 1,300 million cubic feet equivalent, up 15.7% over last year’s June quarter. With gas prices so high thanks to the demand for summer air conditioning–man, it is hot here–they should report a great quarter. Buy GSX up to $4.50 for my $9 target.
Infinity Energy Resources (IFNY) got some great news on the Fourth of July when the Autonomous Region of the Southern Atlantic voted to approve Infinity’s offshore Nicaraguan exploration and development contracts. They will now buy some seismic data, maybe generate some of their own, and keep looking for partners for this potentially blockbuster leasehold. The stock is trading on the pink sheets at 40 cents a share, and remains a buy all the way up to $2 for a $7 first target based on the ultimate value of their Nicaraguan concession.
Robotics MegaShift
iRobot (IRBT) recently filed an 84-page patent for a robot lawnmower. The “Lawnba” filing covers an all-electric or a hybrid gas/electric mower in various configurations, from the Roomba disc shape to a pentagon, with two to five cutting heads. It uses optical and acoustic sensors to stay away from hard surfaces, water or barriers, and can sense uncut grass. The barrier methods include perimeter wires, solar-powered spikes GPS navigation as well as a radio beacon. RFID tags or proximity sensors keep it from running into pets and kids. Very cool! There are others already on the market, such as the perimeter-wire Robomower from Friendly Robotics, an Israeli company:
And the no-wire-needed Lawnbott LB1200:
But iRobot has the distribution channels, and if they can get in on the market for less than $1,000–what are all the teenagers going to do for summer work? The patent covers a recharging station that the Lawnba would return to on its own, an edge trimmer, a clippings bag that could be dumped at your compost bin, and a grass comber to fluff the grass prior to cutting. Maybe they can repurpose the Luge gutter cleaner to go after dandelion roots. IRBT is a buy up to $15 for my $30 target.
Security MegaShift
SiRF Technology (SIRF) has a fully diluted market capitalization around $135 million. The company’s stated book value is $490 million, and after subtracting out goodwill and other non-tangible assets, it is $197 million. They’ll do about $270 million in sales this year. So the stock sells for less than 70% of tangible book and 50% of revenues per share. It’s worth at least $10 per share today in a buyout, and $20 if they stay independent under a new CEO. For you value buyers, SIRF can be bought up to $8 for a $20 target with low risk.
WiMAX MegaShift
John T. asked: “Alvarion has moved down in the last 45 days from a high of about $9 to a trading range of $6.00 to $6.50. Is this a sign of weakness or a buying opportunity?”
Clearly this offers an excellent buying opportunity. Additionally, Alvarion (ALVR) just qualified for the U.S. Department of Agriculture Rural Utilities Service program and was granted “Buy American” status. These are required for operators requesting federal funds from the Rural Broadband Access Loan program to buy and deploying broadband systems in rural areas. Over the last six years, Rural Utilities Service has provided almost $6.5 billion in telecom grants, loans and loan guarantees for rural development. Alvarion’s BreezeMax is the first and only licensed WiMAX system they have accepted. ALVR is a Top Buy up to $11 for my $17 target.
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Subscriber Daniel P. wrote: “I would like to get your view on financial stocks. Is it time to buy or sell?”
I spend a lot of time looking at companies and stocks that probably will never become recommendations, partly because they are important customers for technology companies, and partly because they have important implications for the whole market. That’s why I’m concerned that most investors don’t realize that General Motors (GM) and Ford (F) are going to file for bankruptcy. Most don’t know that a crucial portion of the U.S. banking system’s reserves are in agency debt from Fannie Mae and Freddie Mac. These things can blindside one’s portfolio.
I think it is too early to invest in financial stocks, but I do think a relief rally is coming as soon as Bernanke and Paulson bite the bullet and formally guarantee Freddie and Fannie’s debt. So there is a trade, or at least a better opportunity to sell financial stocks, coming up. I would rather own real growth companies in that kind of market, and use the bounce to sell financials and get into other things. I still think a bear market is coming starting around April of next year, and the Fed and Treasury are asking for tools to preside over the orderly liquidation of financial institutions that get in trouble. By this time next year, that will be most of them.
Incidentally, in the bank failures so far this year, the FDIC has paid out on their $100,000 per account insurance. But they have not paid for anything over $100,000, and some people and companies have lost millions. On a side note, when the Fed closes a bank, the ATM stops working and they don’t cash checks for sometimes four to six weeks. If you are not at one of the “too-big-to-fail” banks, be careful.
By the way, do you know the difference between a pigeon and a mortgage lender? The pigeon can still make a deposit on a BMW.
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