As you know, I’ve been very cautious about the beginning of 2007 for several months. There are powerful deflationary forces loose in the world. Housing prices are falling. Outsourcing, an undervalued Chinese yuan and the Internet are bringing down the prices of finished goods. High gasoline prices hurt consumer spending last summer, and geopolitical instability means those prices could return anytime. High levels of consumer debt could lead to spending cutbacks. Retiring baby boomers are about to claim Social Security benefits when there is no money in the Trust Fund, so either Federal taxes are going to have to be raised (deflationary) or Federal spending has to be slashed (deflationary).
These are powerful forces that could create potholes in the market’s path early in 2007. And the one area that will be most obvious to investors is the housing market. Hardly a day has gone by that we haven’t heard about the housing market for the last year, or more. Real estate has become a benchmark for investors to measure the economy’s strength. And when the news is bad, they start getting antsy.
The evidence is clear to me that the housing sector has a long way to fall through 2007. Yesterday, the minutes from the Fed’s December 12 meeting were released, revealing a very bleak assessment of housing. And, if that’s not enough to confirm my outlook on the housing market, at the same time, Lennar Corp, the biggest U.S. homebuilder, said it experienced a loss in the fourth quarter and they “see no signs of a recovery in the housing market.”
This sector also accounted for a large share of the growth in GDP and employment over the last four years, so a long decline in activity will have a very noticeable effect on the economy. In addition, if housing prices also fall with activity, as I expect, there will be an extraordinary broad impact on consumers because this is a highly leveraged sector — lots of debt relative to equity for most everyone who bought homes in the last five years.
Yet the Fed says that while inflation is moderate, they are worried about it taking off again. Given that they are growing the money supply at 24% a year while real GDP is growing 2.4%, they should be worried. They are building in 20% per year inflation.
The question I have been asking myself is: Why are they doing that? What do they see that would cause such a radical policy? We know that Ben Bernanke fears a deflationary spiral more than anything, if only from his famous statement that the government could always stop a deflation by dropping money from helicopters. After reading the Fed minutes, I think I know what is going on:
In an economic sense, if 24% growth in the money supply only buys 2.4% growth in real GDP, the deflationary forces must be very strong. But asset deflation in a debt-heavy economy is a prescription for a disaster much larger than the 1929 Crash. So Bernanke has decided to inflate our way out of the problem, which means:
- Debt holders wind up with paper worth much less than they expected;
- The huge foreign holdings of U.S. government debt lose most of their value and can be paid back with cheap dollars;
- The Social Security burden is greatly diminished, as all those folks living on their $1200-a-month Social Security check find out that it barely covers their weekly food bill (Cost of living adjustments (COLA) provide some relief, but constant jiggering with the Consumer Price Index keeps the COLA far behind reality — as it is today);
- The U.S. dollar loses most of the rest of its value;
- Assets valued in dollars soar in price:
- Real estate, perhaps after a period of high foreclosures clears out the weak hands;
- Oil, gold, silver, forests, agricultural land, industrial metals;
- Stocks of businesses that can stay profitable in this environment, or own valuable assets offset by fixed-rate debt.
What does this mean for us, or more importantly, how will our technology investments be affected if the Fed continues to print money at a 24% annual rate? Technology has always been deflationary, thanks to Moore’s Law. The prices of computing power, communications bandwidth, consumer electronics and everything else associated with electronics fall sharply every year. Technology company managers have been prospering in a deflationary environment for 35 years or more. Many of these companies provide crucial pieces of the computing and communications environment that the world needs to buy through thick and thin. They also sell 40% to 80% of their products overseas, and can take advantage of a weak dollar to be aggressive on prices and take market share.
On the other hand — isn’t there always an “other hand”? — tech companies usually don’t have much debt, so other stocks may look attractive to investors in the hyperinflation scenario. They also don’t own minerals in the ground or real estate, which may make other investment opportunities relatively more attractive.
But I keep coming back to the idea that in either a deflation or a runaway inflation, people need to work as effectively as possible and companies need to compete globally using the Internet-based model of product development and production, with customer service-based selling. When the avian flu breaks out, it won’t matter much to Gilead if we are in an inflation or deflation. The terminal prostate cancer patient will still get Dendreon’s Provenge, whatever the value of the dollar. People won’t give up their cable TV until after they’ve given up their Starbucks latte — and you know that isn’t going to happen.
What all this means for the stock market in the long term is that it will go much, much higher to reflect the falling value of the dollar. But the short term is still an unknown. The S&P 500 came back from its four-day holiday, the longest close since 9/11, with a dipsy-doodle yesterday that ultimately, yet again, rejected the idea of going much under 1414. That means a possible high of 1440 is still in the cards, and makes it even more likely that we will see a sharp, possibly deep drop from that level over the next few weeks.
However, and this is a big one, if the S&P can crack through 1440 to the upside, I believe that we will be headed for all-time highs over the next couple of years. The 1440 level is that important. Breaking it might mean the big money has caught on to Bernanke’s game and wants out of cash that is declining in value and into assets. If we see the prices of oil, gold and stocks all going up together, we will have very clear evidence that a big move is underway. The most amazing thing about these terminal moves — and I am not using the word “terminal” lightly, as this would be the end game of a 10-year cycle — is how far they can extend. We saw it in 1997 to1999 in dotcom stocks. We may see it in 2007 to 2009 in virtually all stocks.
Between the New Year’s holiday and the day of mourning for President Ford, there hasn’t been a lot of news on most of our MegaShifts, but I have some updates and analysis on recent events with some of our stocks.
Avian Flu MegaShift
Neville emailed: “This time last year, there was extensive media coverage in Europe reporting the inexorable advance of the avian flu H5N1 virus. First in the Caucasus, then in the Baltic and Black Sea, in Eastern Europe, in Western Europe, in Scotland and ultimately in Ireland. Countless WHO and public health officials and various ‘experts’ all had their moments of media attention, accompanied by scenes of people in white protective clothing picking up dead swans. This year, nothing! Was this H5N1 frenzy inspired by the bio-pharma industry to extract major government research support and expenditure to stockpile their products?”
Shhhh — it worked! Seriously, although we own the stocks for that very reason, I do not think H5N1 is some sort of scam. Right now, migratory birds are wherever it is warm — Africa, Mexico, and the like. Most of those areas have very poor monitoring programs for bird flu. The birds are mixing, sharing water and nesting grounds, and passing H5N1 around. The inexorable advance you refer to will come in the spring, as the birds start migrating north through Europe and the U.S. to their summer quarters in Canada, Scandinavia and northern Russia. That’s when the news flow will pick up. Warmer weather should also bring a lot more bird flu cases in Indonesia, China and the rest of Asia, which is the most likely area for the virus to mutate into a human-to-human airborne form.
Biotech MegaShift
Metabolic Pharmaceuticals (MBLPF) announced that they completed their OPTIONS Phase IIb trial for obesity/weight loss on December 18, with results expected in March. They said that the number of completing subjects comfortably exceeded the statistical design goal, with 407 people completing the 32-week protocol in one of the four arms of the trial. The last trial, when they missed their primary endpoint because they met only the 90% confidence level instead of the required 95%, had only about 35 people completing each arm. The more people, the more likely they will hit the 95% level. Recall that in the first trial, they hit one of the secondary endpoints at the 99% confidence level, even with fewer total subjects.
The primary endpoint is weight loss over 12 weeks, with a secondary endpoint of weight loss over 24 weeks. The previous study showed the drug was very safe and easily tolerated, with an average weight loss of 4.4 pounds in 12 weeks.
The company has spent $31.5 million to $35.5 million on this drug so far, and the Phase III trials will have to involve several thousand subjects in the U.S. and Europe, as well as Australia, and cost north of $80 million. Metabolic expects to begin a Phase III study in late 2007 or, more likely, 2008, and I think that they will do that with a partner, unless their stock skyrockets after the March clinical trial results announcement and they sell more shares.
This drug is also useful for osteoporosis, so Metabolic could license the weight loss indication and continue work on their own on osteoporosis. Their second drug for pain also looks good. They now have an oral version of that drug, with obvious advantages over the injectable version.
MBLPF is a good buy either in the U.S. up to 56 cents or in Australia, up to 75 Australian cents, looking for a $4 stock over the next few years.
Content on Demand MegaShift
Michael wrote: “I am intrigued by PRAM. Does Samsung have a patent on this process?”
Yes, they do. I was hoping to recommend Samsung when they listed on the New York Stock Exchange, but it appears that they have decided not to list due to Sarbanes-Oxley. PRAM is the real deal and should replace flash memory over the next five years. Toshiba, SanDisk and Micron will be the biggest losers.
Telkonet (TKO) drew emails from Grady and Edwin. Grady asked: “What is going on with TKO? Has it been delisted? When I did a search for the company on the Internet, I came across a Lemon Stock website that had very negative things to say about the company and its approach to business.” Edwin added: “The website Yahoo Finance’s page for TKO shows $5.2 million cash on hand. Do you think the company is going bankrupt within six months at their current burn rate?”
I’m not sure what caused Grady to think that Telkonet has been delisted, as the symbol TKO brings up the stock price immediately. The stock jumped 30% intraday on December 26 as four million shares traded, after they announced that the Transportation Security Administration (TSA) and the Army completed their evaluation of the iWire Broadband over Power lines system. iWire was approved for deployment, beginning with four airports starting this month.
Clearly, this evaluation has been going on for some time and is probably part of an Electronic Data Systems (EDS) contract with the TSA. It’s a big win for TKO, and there will be many more like it coming.
The company also announced that it has installed iWire systems at substations owned by four major utilities. These systems are used to monitor the performance of the substations, delivering the data over the electric line. That lets the utility manage the substation remotely and centrally, allowing them to balance the grid and be aware of any problems immediately.
Each substation uses about $5,000 of TKO equipment, and there are 70,000 substations in North America alone — a $350 million opportunity that is TKO’s for the taking. Currently, Telkonet is in negotiations with 10 more utilities. Market researchers Newton-Evans think that total global spending on substation automation and integration programs is in the $550 million to $600 million range, with an overall potential market size of $40 billion.
Telkonet Energy Systems has been able to close deals and install equipment very quickly, and this could turn into the biggest part of the company in the near term. The company is about to announce a big deal with a distribution partner that specializes in selling to utilities. This whole business is a bluebird for us, as the stock is worth my $15 target based on their other businesses.
So, I’m not sure what Lemon Stock doesn’t like — Telkonet’s technology lead or patent portfolio? Long list of showplace installations? Exclusive contract with EDS to wire Army and Marine bases all over the world? Opportunity to grab a $350 million market in substation monitoring? Because that sounds like a winner to me.
As for TKO going bankrupt in six months: Out of the question. They would simply raise more money, like the $9 million that they raised in the September quarter. I am still expecting a large investment from a strategic investor above the current price of the stock, but even a couple of more of these big positive announcements should get the stock up to the point where they can just raise a little money at a time, as needed. TKO is a Top Buy up to $5.
New Energy Technology MegaShift
Infinity Energy Resources (IFNY) is progressing on the path I described to a much better valuation. They sold their two oilfield service companies to a private buyer in mid-December for $52 million, used the proceeds to pay off the $50 million in convertible senior debt that has been overhanging the stock with constant stock sales and signed a terms sheet with an unnamed leading energy bank for a $20 million revolving line of credit. On the conference call, management said that this deal should get rid of the immediate pressure on the stock, as soon as the former debt-holders have sold the remaining shares that they hold, and will let Infinity resume its drilling programs in Texas and Colorado. Also, now that the company is a pure exploration and production operation, their investment banker will start circulating a booklet to sell assets or the whole company. IFNY has already had expressions of interest from other companies and private equity firms. I am hopeful that they stay independent, but extract a lot of value for shareholders from the huge 1.4 million acre oil lease concessions they won off Nicaragua.
Gary and others wrote: “The stock response to the sale was small, but wasn’t this supposed to be a large catalyst to a big stock price jump?”
Yes, and I still think it will be. The transaction took place at a slow time of the year, and IFNY probably saw some tax loss selling in the final week of the year, especially when volume picked up on the last day. The drop in oil prices this week kept the pressure on in the short-term, but this transaction is excellent news for us, with management executing exactly on the plan they laid out to get the stock up.
As I said above, I think the recent “weakness” in oil prices is a short-term thing, and longer-term you must own real assets as long as the Bernanke Fed is bent on driving the dollar down. With the old senior notes paid off, IFNY is in better fundamental shape than ever, yet the stock is near its lows. IFNY is a Top Buy all the way up to $5, and I still think my $9 target is just the beginning of the wealth to come.
Google Short
If the S&P 500 breaks up through 1440, we are not going to short Google (GOOG) any time soon. But if it breaks below 1410, I think the handwriting will be on the wall. The most bullish analyst on Google is at Piper Jaffray. In early 2006 he raised his 12-month target price to $600, and the stock never came anywhere near that. In fact, it went into an immediate swoon from $475 to $330.
This week, he raised his 12-month target price to $630, or 35X his earnings estimate for 2007. But if the stock market starts to signal an economic slowdown, advertising spending will be at risk, and ad spending is about 120% of Google’s earnings (almost everything else loses money). To the extent his $630 target can prop the stock up for a while, we will benefit from a better short entry point. Stay tuned.
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