I don’t believe in making broad market predictions. I just watch what the market is trying to tell me on an hourly, daily, weekly and monthly basis, and then I identify the critical energy levels that should provide support and resistance. When the market fails to hold at a support level, the next lowest down level becomes the new one to watch. When it breaks above a resistance level, the next highest one becomes the next target.
So, it was very unusual for me to send you Tuesday’s Flash Alert advising the purchase of insurance puts, because the S&P 500 had survived several tests down to the 1490 to 1500 area. Surviving is good, right? Well, usually. But a healthy market will go down to test support and build up negative sentiment, and then use that stored up energy to move up sharply and break through the next resistance level. If it keeps being attracted over and over again back to a support level, after a while each test becomes harder to survive, and if there is a failure after several successful tests, the resulting down move can turn into a waterfall. In this case, I suspected that breaking 1490 would force the short-term bulls, like me, to give up our positive outlook for the next few weeks, and that widespread change of opinion is what can turn a drop into a waterfall. And that’s what happened yesterday.
The whole situation is complicated even more by the Plunge Protection Team’s activities. Now that Treasury Secretary Paulson has admitted that there is a working group on market functioning, the only question is how often they actually intervene and how much. I doubt we will ever know the truth, but from watching the way the stock market acts in the last hour of trading, I suspect that the answers are “often” and “big time.” The problem is that Wall Street now essentially dares the PPT to not act by shorting stock prices all day long, covering and going long about 2:30 p.m. Eastern time, and then waiting for the PPT to rally stocks. If the PPT doesn’t show up, Wall Street will start to disgorge stocks in a hurry, beginning a mini-waterfall that makes it even harder for the PPT to turn the market back up. So the PPT usually performs its function on cue. Unless it wants to mousetrap the traders, as it did in yesterday’s final hour, and give them the painful choice of booking losses or going home with more long stocks than they really wanted to hold.
And that’s the reason why I sent you the Flash Alert yesterday. We are right in the middle of a difficult market pattern that could easily overwhelm the PPT, and that would really hit stocks hard. It probably won’t happen, but if you ever needed insurance against such a decline in the last few years, you need it now.
In the real economy, things look much better. The 4.9% productivity growth that was reported yesterday for the September quarter should lay aside fears of labor cost-related inflationary pressures, at least for a while. The Fed’s ongoing destruction of the dollar that I’ve been railing about all year will force wages higher next year, simply to keep people’s real incomes from falling too much. Even the heavily-manipulated government inflation calculations won’t be able to hide what’s coming down the pipeline. Gold is now at a 27-year high, around $825, and oil is at all-time records near $100 a barrel—that’s not by accident.
The dollar slipped another half a percent yesterday against a basket of currencies. In last week’s Radar Report I calculated that the dollar would be worthless by August 2010 at the recent rates of depreciation. At yesterday’s rate of decline, it will be worthless by May 23, 2008. In that environment, real assets maintain their value by going up as the currency falls. In addition to gold and other precious metals, commodities and real estate, that includes ownership of real companies — especially nimble companies in the fastest-growing area of the world economy. That’s where we are focused, and unless the whole world is about to go back to mainframe computing, landline telephones and black-and-white TV, we will inevitably win.
As earnings season winds down, I want to continue reviewing several portfolio companies that reported results, especially the biotechs, and answer some of your questions. Next week I will catch up on the energy companies, American Science & Engineering (ASEI) and the WiMAX MegaShift. Our only companies reporting next week are Crucell (CRXL) on November 13, and Dendreon (DNDN) and Rochester Medical (ROCM) on November 15, although I am looking for an Integral Technologies (ITKG) 10-Q filing with no conference call.
Avian Flu MegaShift
BioCryst (BCRX) reported third-quarter earnings this morning. They did $20.5 million in revenues, almost double my $10.5 million expectation, and lost 32 cents a share, which was a bit of a bigger loss than the 30 cents that I was expecting. The bulk of their revenues came from a Health & Human Services (HHS) grant to study peramivir, so the more money they spend, the more they are reimbursed and the higher their revenues — but the loss is not affected. On the conference call, management said that they are proceeding with the small trial of a longer needle length and are still getting data from the intramuscular Phase II trial that was not statistically significant. However, they still expect to file for and start a Phase III trial in time to catch the flu season this winter, and they still have HHS support for that timeline.
The analysts’ questions had a mildly negative tone on the order of: “What happens if HHS decides to stop funding you?” But I didn’t hear a single new negative, so I have no idea why the stock dropped 72 cents today. I see no reason to change my recommendation: Buy BCRX up to $13 for my $30 target after successful Phase II intravenous results are announced or IV peramivir is approved for avian flu.
Crucell (CRXL) will report September-quarter results next week, and they should benefit from the back-to-school “vaccine season” and coming flu season. Management expects a much stronger second half of the year than the first half. To reiterate, the one analyst publishing estimates is expecting $109.4 million in sales and a loss of 10 cents a share. I expect that they will do closer to $115 million and breakeven. For December, the lone estimate is for $97.4 million and a loss of 17 cents. I think that the company will guide for $105 million and a loss of around five cents. CRXL can be bought up to $28 for my $50 target.
Biotech MegaShift
CombinatoRx (CRXX) reported earnings last week. They did $3.0 million in sales and lost 49 cents a share, pretty much on target. They will lose about $50 million this year and end up with $105 million in cash, thanks in part to the recent $33 million stock offering. As I said last week, what really counts is the outcome of their numerous Phase II trials.
In the September quarter, CRXX started a Phase IIb trial of their most advanced compound, CRX-102, in knee osteoarthritis. They also started a Phase IIa proof-of-concept trial of CRx-401 in diabetes, and a skin atrophy Phase II trial of CRx-191. Today, they began a Phase IIa trial of CRx-191 in psoriasis. By the end of the year, I expect them to complete patient dosing in a Phase IIb trial of CRx-102 in rheumatoid arthritis and a Phase IIa trial of CRx-191 in plaque psoriasis. They should also report the results from the CRx-191 skin atrophy trial.
Then they will take good Phase II results and find partners to fund the Phase III trials. It’s a great business model because their technology gives them a steady stream of new drug candidates. Continue to buy CRXX up to $7.50 for my $16 target.
Dendreon (DNDN) will report next Thursday after the close. I am hoping that they can say something about when they think the interim peek data will be available next year. They may discuss some of the related programs in breast and head and neck cancer that they have funded recently, although these are early stage. I’m not expecting to hear anything specific about a European partner, although they could fool me here.
Robin asked: “Would you please comment on the Motley Fool’s ‘Dendreon: the Scariest Stock’ blurb. They made quite a show manipulating the statistical data, implying that placebo patients would live longer than the non-placebo patients in their current trials. If they’re right, they’re right, but I had a hard time following their logic.”
Was that logic? It was just silly statistics. Basically, the author said that if you put one normal curve on top of another, and one has a somewhat higher mean than the other, then there will be lots of area that overlaps. That is always true. To quote him, because he deserves it:
“…if the study was run 100 times, then 95 of those times the placebo patients would have median survival times in the 12.8 month-to-25.4 month range. Unfortunately, 95 of those times the Provenge patients would have median survival times in the 13.6 month to 31.9 month range. So if randomness wasn’t in Dendreon’s favor in this study, placebo patients could easily have lived nearly twice as long as the Provenge patients (depending on the sample used). Yikes!”
In other words, the area from two standard deviations below the mean to two standard deviations above the mean for the placebo curve runs from 12.8 months to 25.4 months. The same range for Provenge runs from 13.6 months to 31.9 months — higher at each end. The mean for the placebo is 19.1 months and the mean for Provenge is 22.8 months. The difference of 3.7 months is in Provenge’s favor, but was not statistically significant.
Now, there are two ways to get to statistical significance in the current study. One way is to see a greater separation between the two curves. My back of the envelope is that if Provenge had shown a difference of over five months in the first two studies, it would have been statistically significant.
The other way is to increase the sample size. The first two studies treated a total of 225 people. The current study just finished enrolling over 500 patients. So, even if the difference stays at 3.7 months, Provenge will show statistical significance. (Again, that is my back-of-the-envelope estimate). Now, here is the interesting part. The interim peek at survival will happen around the middle of next year, and I believe will include 400 of the 500 treated patients who have survived at least a year. Management tells me that the peek is “powered” to show statistical significance even if the clinical results are similar to the prior two studies. So if Provenge can maintain a 3.7 months difference, the results this time will be statistically significant just because the sample size is bigger.
Finally, let’s address his statement that “placebo patients could easily have lived nearly twice as long as the Provenge patients (depending on the sample used).” That is partly true. 2.5% of the placebo patients lived longer than 25.4 months. 2.5% of the Provenge patients lived less than 13.6 months. So the odds of any one placebo patient living twice as long as any one Provenge patient are 2.5% times 2.5%, or 0.000625%, or about 1600-to-1. “Easily?” Yikes, indeed. DNDN remains a buy while it is under $8 for my $40 target after Provenge is approved.
Isolagen (ILE) filed their 10-Q report with the SEC on Monday, the same day that they held their annual meeting. Remarkably, they didn’t even put out a press release about the quarter. But I read the 10-Q and basically there is nothing new to say. They have enrolled the two 200-patient clinical trials at 13 sites to treat nasolabial folds and have begun treatment. They said nothing about when we might see the actual data. However, at the CIBC Healthcare Conference the next day, management said that they expected all injections to be completed by the end of the year or early January. Six months after that they will have all the data, so they should be able file with the FDA under their Special Protocol Assessment towards the end of 2008. Buy ILE under $4.50 for my $9 target.
Rochester Medical (ROCM) will report earnings on November 15. As a reminder, I am looking for better numbers than the one analyst that publishes estimates. He expects $8.4 million in sales in the September fourth quarter and seven cents a share, followed by $8.7 million and another seven cents in the December period. That would have ROCM coming in at $32.6 million and 23 cents for the September 2007 fiscal year, and the lone analyst is looking for only $38.9 million and 34 cents for fiscal 2008. I think that they can beat $40 million and do 40 cents.
A subscriber, Don, asked about the buyout possibilities at ROCM, and that is a very realistic exit strategy for these entrepreneurs. But I expect them to settle the Covidien and Novation lawsuits first, and get that cash on board. I also don’t think that they’d sell at these low prices. ROCM is a Top Buy up to $23 for my $40 target.
SXC Health Solutions (SXCI) reported third-quarter results this morning, and beat the reduced expectations. Revenues were in line at $22.2 million, but they hit 12-cents-a-share pro forma compared with the consensus for eight cents. They guided sales for the year to a range of $92 million to $93 million, right on the consensus for $92.5 million, and earnings to a range of 55 cents to 60 cents a share, above the 53-cent consensus.
The stock sold off 41 cents today on the news, and it is back below my raised buy limit, although not below the original $13 limit. Buy SXCI under $15 for my $30 target.
China MegaShift
Last night, following Wednesday’s drop in the U.S. market, the Hang Seng Index in Hong Kong dropped 3.2%, and the Shanghai Composite Index lost 4.9% — its biggest one-day decline in four months. It’s clear that the Chinese market is tied to the U.S. and vice-versa, through trade if nothing else. But the connection also goes the other way, and I think that the Chinese stock market implosion that is coming will be another force dragging down U.S. markets.
In 1997, when Great Britain handed over Hong Kong to Chinese rule, Hong Kong stocks rallied sharply for the six months before the transition, and everyone bought the “red chip” stocks that had strong connections to the mainland. About two weeks after the turnover, that bubble popped.
This one is worse. Shanghai Exchange investors have not been able to buy stocks outside of the mainland, and they’ve never been through a bear market. They think stocks only go up, with dips like yesterday just providing a chance to buy more shares cheaply. They mostly buy the state-owned companies because they appear connected and protected. In reality, many of those companies are technically bankrupt or don’t make any money under honest accounting.
Consequently, shares of a stock like PetroChina trade on the Shanghai Exchange at a premium to what they trade for in Hong Kong or on the NYSE. How much of a premium? Triple. You read that right. PetroChina is worth 200% more at Shanghai prices than in Hong Kong or New York. Based on the Shanghai price, the company is worth $1 trillion. That, my friends, is a very big bubble. Warren Buffet recently sold all of his PetroChina shares.
As you know, some of the mania has spilled over to Hong Kong, because China was about to allow mainland investors to buy on that exchange. But over the weekend, Premier Wein Jia-bao said that Beijing needs to do more research and planning before changing the rules for individuals. Whoops! The 50% run-ups in individual Chinese stocks over the last three months suddenly look a tad enthusiastic. Mutual funds will still be allowed to invest in Hong Kong, and I suspect it could be years before the rules are changed for individuals. Between now and then, I am still looking for a huge correction.
Content on Demand MegaShift
Silicon Image (SIMG) tanked after the conference call last Thursday, and I have spent a ton of time trying to find out if there is an underlying reason that I am missing. I had several concerned emails about the situation, including one from Neville: “You did not issue a Flash Alert last Friday, and this implies that you did not hear anything worrisome on their conference call. Is SIMG now a Super Top Buy or a Top Sell?”
Management said only one thing on the call that accounted for the drop: They think there is a chance that their 2008 revenues could be flat to down, because they have had some product delays that might mean they don’t win sockets until 2008 for products that will ship in 2009. There is no doubt that SIMG is the technical leader in the HDMI standard, and there is no doubt that the use of HDMI in consumer electronics and laptops is exploding. When we bought the stock, there were 400 customers using HDMI. There are now about 770.
This was their new Chief Financial Officer talking, and he promised a lot more detail at their Analyst Day on January 24. I think he is being overly conservative, considering that some retailers like Best Buy no longer even carry analog TVs, and every new set will be digital by the middle of 2008. And the analog signal will be turned off on February 15, 2009. I expect next year to be a huge year for digital TV and laptop sales, as well as smart phones and media centers. Only 11.3% of Americans have a high-definition TV, and why would you buy digital but not high-def at this point? SIMG’s technology is already designed in to a lot of products that will be big sellers next year. The CFO has committed to watching R&D expenses, so the odds of them actually having a flat revenue year or a down earnings year seem pretty low to me.
Not to the market, though, which clobbered the stock 25% after the announcement. SIMG now trades at about 10X trailing earnings, with almost no debt and $130 million in cash. Silicon Image is very cheap going into the holiday season, and I think the Analyst Day meeting will be a positive surprise. SIMG is a Top Buy up to $13 for my $20 target.
Market Outlook
In last week’s Radar Report I wrote that: “…I would not be surprised to see a quick probe down to 1497 tomorrow or Monday, which should be just as quickly rejected.” We got the probe down, but when it was not quickly rejected, I sent Tuesday’s Flash Alert. As I said in the Alert, this drop could extend all the way to 1326. At that point, the VIX (Fear & Greed) Index, which jumped 24% yesterday alone, would be sky high, and there should be at least a rally back to 1490. If the VIX doesn’t fall too quickly during that rally, there should be enough remaining juice to finally make the move over 1555 to 1607, or even 1690. But we will burn that bridge when we get to it, as they say.
The St. Louis Fed President William Poole must be very miffed about the way he is being ignored in his last six months before retirement, because he must have known that his comments yesterday would contribute to the sharp market drop, even though I thought that they were great comic relief. He said that the central bank will not raise interest rates when it meets December 11. Excuse me — was anyone suggesting that the Fed is about to raise interest rates, with their buddies on Wall Street still in deep toxic credit doo-doo? I must have missed that memo.
In 1990 and 1991, I was running an all-short fund of $40 million and doing quite well shorting the banks, which were loaded with nonperforming real estate debt. I could show you clear as day that Wells Fargo and Citigroup were bankrupt under the accounting rules for recognizing nonperforming loans. The Wall Street Journal interviewed me for”Heard On The Street.” It was just a question of when the SEC would force the banks and their accountants to tell the truth.
You can guess what happened. The SEC never forced anybody to do anything. Someone got Warren Buffet to buy a slug of Wells Fargo, and some sheik to put millions into Citigroup after a secret, personal visit by the Secretary of the Treasury. All of a sudden I was running a $25 million short fund. And they may be about to play the same game again. This week, Citigroup’s CEO followed Merrill Lynch’s into the Hall of Shame, cushioned by $150 million or so in severance benefits. Citigroup is busted again — the $8 billion to $11 billion charge that they admitted to last weekend isn’t nearly big enough. But while it appears that GM will be allowed to go bankrupt, they’ll figure out a way to save Citigroup again. But it won’t be easy, because the problem this time is huge.
The New York banks and brokerage firms all played the same game, leveraging up their equity to buy high-yield mortgage-backed securities. In most cases, some or all of these positions were further complicated by becoming the basis for derivative securities. Once you get down to the toxic junk level, all these securities have one thing in common: There is no bid. No one knows what any of them are worth, if anything. They don’t trade. So, here are the big sinners, ranked by the ratio of toxic junk mortgage-backed securities to equity:
| Toxic Junk (in billions) | Equity (in billions) | Ratio | |
| Morgan Stanley | $88 | $35 | 2.51 |
| Goldman Sachs | $72 | $39 | 1.85 |
| Lehman Brothers | $35 | $22 | 1.59 |
| Bear Stearns | $20 | $13 | 1.54 |
| Citigroup | $135 | $128 | 1.05 |
| Merrill Lynch | $16 | $42 | 0.38 |