I guess it’s just me, but the weakness in housing, consumer spending and now semiconductor orders is making me very nervous about the real pace of economic growth in the December and March quarters. With the Dow Jones Industrial Average hitting new highs almost every day, the “What, me worry?” market continues to roll on. The way that investors and “experts” are ignoring critical data that point to a downturn in the current and upcoming quarter has me shaking my head. Today, I’d like to take a look at three areas of the economy that point to trouble ahead, and hopefully, dispel any cheerleader speak you may have picked up by watching the tube.
Housing
Housing accounted for 40% of the growth and job creation in the last upturn, and it is now in a nasty down cycle. I’ve been using the phrase “falling apart” when discussing the housing market, and have had some emails questioning such strong language. But yesterday the National Association of Realtors published their latest quarterly survey, and its results validate my view that housing is in a tumble. The survey started with this wonderful first paragraph: “Conditions for home buyers improved during the third quarter as existing single-family home prices in many metropolitan areas experienced corrections, and most states saw sales activity below a year ago,, which helped to build housing inventories.”
If that isn’t a silver lining in sheep’s clothing, I don’t what is. Sure, it’s good news for the few people buying homes, but it’s very bad news for the huge number of people holding them. Sales activity fell in 38 states, with both coasts among the hardest hit. The chief economist said (my commentary in italics): “It’s no surprise that overall home prices are slightly below a year ago. We expect this trend to continue in the months ahead, but [cross your fingers] we’ll see modest appreciation in most of the country in 2007.”
If you need any further evidence on how long this housing nosedive is going to run, in a speech to a private group in Canada last month, Alan Greenspan said: “The worst of the housing slump is over.” I’m not sure why or how the worst is over, but Alan went on to tell the Canadians that the housing boom did not happen because of the “1% Fed funds rate or from the Fed’s easing. It came from the collapse of the Berlin Wall.” Honest. He really said that. Of course, if the housing bubble bursts on top of the Internet stock market bubble burst, his legacy may be a reputation as the double-bubble banker.
No matter what Alan thinks, last Friday, the Commerce Department said that October housing starts plunged 14.6% percent from September to a six-year low, and were down 27.4% from October 2005. Single-family housing starts have fallen by more than a third since the beginning of the year, and October housing permits declined for the ninth consecutive month — a record.
Consumer Spending
Consumer spending accounts for 70% of GDP. I went through these numbers here last week. As I said, I find it bizarre that some people who should know better are saying that consumers are picking up the torch as business spending slows down, or that the drop in gasoline prices means consumers are back to their old spending ways. Retail sales dropped 0.8% in September and 0.2% in October. The drop in spending on gasoline since July is $6.7 billion, while spending on everything else is up only $2.9 billion.
Semiconductors
As long-time readers know, I track semiconductor sales and orders very closely. Semiconductors are the oil of technology — they are everywhere — and it is very hard to have good PC sales, good cell phone sales and good consumer electronics sales, if you have poor semiconductor sales.
So, I was surprised when the Semiconductor Industry Association (SIA) put out their 2007 forecast this week, with hardly a tip of the hat to what has been happening in the marketplace. They said that consumer demand for electronics, especially cell phones, digital music players and digital televisions, will drive semiconductor sales up 10% in 2007 to $273.8 billion, up from a record $248.8 billion in 2006. Then they see another 10.8% growth in 2008 to $303.4 billion. Now, to be fair, that is a slightly lower forecast than the June update, when they expected 11% growth in 2007 and 12% growth in 2008. But they added: “We are in a very strong demand period with good inventory management and high capacity utilization.”
Oh, really? Consumer electronics only account for 19% of all semiconductor consumption. The SIA is counting on more than 20% growth in cell phone sales to total over one billion units this year, yet the big participants, like Texas Instruments, say that there are excess inventories in the field, especially in Asia. The SIA is still forecasting 2006 PC sales growth of 10%, even though Windows Vista will only be introduced for business use on November 30, and virtually every consultant is telling clients not to upgrade until the bugs are out.
I track the book-to-bill or orders-to-shipments ratio to understand where the industry is going, and how strong business really is. The good news is that shipments were still 37% higher this October versus October 2005. But that’s where the good news ends.
Shipments were 65% higher in August and fell to +54% in September. The book-to-bill ratio was below 1.0 for the industry from September 2004 to January 2006, which means orders were below shipments, so future shipments would be declining. The book-to-bill ratio finally went above 1.0 this February, and strengthened to 1.03 in March, 1.11 in April, 1.11 in May and 1.15 in June. But that was the peak. It fell to 1.06 in July and went below 1.0 again in August, to 0.99. September was worse, down to 0.98, and October was even worse than that, down to 0.95.
The reason the semiconductor stocks have been slipping is simple: Orders are below shipments, which means the industry is shrinking, not growing. Sure, the year-over-year numbers are still OK — but not for long. Wall Street knows that, having been through this cycle umpteen times before, and it is getting out of weak areas like NAND flash memory.
The Bottom Line
Housing is very weak. Consumers are pulling in their horns, even on consumer electronics, and excess inventories are hitting semiconductor orders. I’m looking for a modest holiday season and slow GDP growth, possibly negative, for the December and March quarters.
While I don’t think that’s good for the market in the coming two months, I still think there is room for the S&P 500 to make one last run at 1415 before the end of the holiday season.
As I expected, 1401 is turning out to be a minor resistance area. The way I see it, it would take a major market event (accelerating inflation, the Fed, a terrorist attack, natural disaster or a large geopolitical event) to derail this upturn right here. Yet, it looks like all the energy will be spent — all the money will be sucked in — just a few points higher at 1415. That will be especially true if it comes in a rush, looking something like the recent move up to 1401.
Then, the market will use that opportunity to snatch up profits from all the greedy investors who didn’t heed the warning signs. From there, the market will drop back to or through 1401, and we’ll be able to tell if the market reloads for a run to 1440 and another snatch-and-grab job on any remaining bulls, or if it will retrace all the way back to 1292.
A run to 1440 is the low probability scenario right now, as it looks like the long-term money has been spent, and this last blip up to 1415 will be done with speculative and momentum money only. It is no accident that Google (GOOG), the poster child for momentum money in this whole market move, cleared $500 today. That kind of buyer will turn tail and run at the first sign of weakness, and I would not be surprised to see a 10-point drop in the S&P in an hour after 1415 is hit. And, yes, when the time comes we will be re-shorting GOOG for a decline in U.S. advertising spending in 2007.
The Fear & Greed Index — the VIX — finally went into single digits on Monday and shows the near-total complacency in this market. It should be able to get down to 9.50 as the S&P gets up to 1415, and if they both reverse there (VIX up, S&P down), I’ll be even more sure a substantial correction is beginning.
Basically, what it comes down to is that the market cannot sustain this rally due to the negative economic data announcements that are coming. There may be a few head fakes over the next couple of months, but this isn’t the type of market to lay all your money on the table.
However, now is not the time to panic. Now is the time to prepare for the probable outcome. Despite the downturn, there will be companies that will not only survive, but prosper. These companies will be part of MegaShifts — unstoppable trends that have the capability to change our lives — and we’re already invested in the best ones to make you money no matter which direction the market takes.
I still think it is prudent for you to get off all margin and hold 50% of your portfolio in cash. So, if you’ve become overweight in a particular position, sell some of your stake. The big, liquid stocks, like Comcast (CMCSA) and Huaneng Power (HNP), are a great place to start, where we’re sitting on 35% and 10% gains respectively. By lightening your load, this will allow you to shelter a significant portion of your portfolio, as well as enable you to pounce on the enormous buying opportunity that will arise from lower levels for a good 2007 and 2008 market during the usually strong second half of the Presidential cycle.
Biotech MegaShift
Biogen Idec (BIIB) drew a question from Franklin: “I see BIIB is moving, as you thought it would. What is our timing for exit on the 2007 LEAPs? What is the last date we can exercise our sale?”
LEAPs “convert” to normal options about six months before expiration — you may remember that from when the BIIB January 2007 contract was assigned a new symbol. So, they expire on January 19, 2007. As for timing, even in a market correction, I think the big biotechs will be immune, as money comes out of Big Pharma due to the Democrat’s victory, and out of all cyclical industries. That money has to go somewhere, and most of the big institutions can’t hold cash, so Big Biotech is an obvious parking place. I still think it is safer to roll the 2007 contract into the 2008 contract, but if you want to hold on to what you have, I expect you can hold them right to the last week. I will remember to update them in the January 11 issue, and anytime I comment on Biogen. For others, sell the January 2007 $45 LEAP (IDKAI) and roll the money into the January 2008 $45 contract (YZUAI) under $12 for my $23 target, or higher.
Dendreon (DNDN) had the bear case rehashed on Motley Fool, which sparked a flurry of letters. Russell asked: “There seems to be a level-headed comment by Brian Lawler of Motley Fool on November 10 that another Phase III trial might be required before approval. If so, a financing would be needed because they will run out of money, with considerable dilution. What do you think are the chances of that? Are we talking about equal likelihood of 100% gain or 50% loss, or a 3:1 likelihood in our favor?”
I think the odds are 9:1 in our favor, but I will be the first to say that a 10% chance of the FDA requiring them to do another clinical trial makes this a high-risk investment. As Lawler said, by this time next year the stock will be a lot higher or a lot lower. He pointed out that only one of their Phase III trials showed a survival advantage, but he failed to mention that the second trial was stopped early with the FDA’s approval, as the two trials taken together provide enough data to make a decision on efficacy.
Steve wrote: “DNDN actions make me wonder. If they had enough cash to make it to approval or close, why would they sell stock at a 15% discount to market? I see it as kind of a positive that they could get the money, but what do you think of their confidence level in themselves?”
The key to your question is in the words “or close.” The FDA could come back to them in six months and ask them to waive the six-month deadline for further study. That has happened in other cases, and the company really has no choice but to waive it. I’ll bet what happened in this case is an investor came to Dendreon and offered money for DNDN shares, because the investor did their homework and believes Provenge will be approved. The private equity guys do a lot of due diligence before they offer money. Dendreon then called their investment bankers to place additional shares, which is an easy job if there is a lead investor. DNDN gets almost $43 million for 13.8% dilution, and the 15% price discount is just standard terms.
Ron asked me to comment on a long post from an Investor’s Hub message board, the essence of which (again) was that the survival data from one successful study and one supportive study is not enough to get approval. The post also included some other points related to the length of the Biologics Licensing Application (BLA) filing, Dendreon’s reduction in planned manufacturing capacity, and the departure of two Chief Financial Officers as further evidence that Provenge is unlikely to be approved. Dealing with them in that order, Dendreon has been very careful with this BLA filing to have every step reviewed by consultants, many of whom used to work for the FDA. Of course, the company began the process by asking the FDA if this data warranted a filing, or if they needed to complete another Phase III before filing. The FDA told them to go ahead. The reduction in manufacturing capacity was part of the cash-saving initiative that included stopping clinical work on other cancers where the Provenge process can be used, and I worry when technical people leave, not CFOs.
In short, Dendreon has had the BLA “reviewed” by ex-FDA reviewers every step of the way, and they are paid to find holes in the filing. That’s the biggest reason I think the odds of approval are 9:1. DNDN remains a Top Buy up to $7, and the additional shares from the latest financing do not change my target price of $14 after Provenge is approved in mid-2007.
Content on Demand MegaShift
Subscriber Li commented: “I do not think (as an engineer) that TKO, UTSI and ZHNE have any technology edge over its competitors. What technologies do you think they have that are world-leading?”
Good question, and it gives me a chance to make a point. Telkonet (TKO) clearly has a substantial technology lead in in-building Broadband over Power Lines, with a broad patent portfolio and an easy-to-install product that works right out of the box. Ambient, their main competitor, has only one installation, that I know of, and it is a much harder installation. But beyond that, TKO has a broad network of system resellers plus the contract with EDS to carry them to marketplace dominance.
UTStarcom (UTSI – part of the China MegaShift) has robust technology in Internet Protocol Television, but I would not say that it is world-leading so much as world-class. They can compete with anyone. What they do have is a wealth of real experience from their Japanese and Chinese installations, and extremely low-cost design and marketing capabilities from the handset side of their business.
Zhone (ZHNE) also has world-class technology in the DSL area, but so do many others. But what sets them apart is that they have great customer relationships and marketing — good-enough technology plus great marketing will usually trounce world-leading technology and lousy marketing. There is no one out there with better technology than Zhone (also true for UTSI and TKO), so it comes down to other factors that will decide who wins. And while TKO and UTSI would still be on my buy list even if they changed CEOs, Zhone has a big plus in my eyes because Mory Ejabat, who built Ascend Communications from a couple of hundred million in sales to a buyout by AT&T for $24 billion, is running the company.
New Energy Technology MegaShift
Subscriber Dean asked: “Between Gasco and Infinity Energy, which do you see as a better investment? They are similar in many ways, and both have done poorly lately, at least on the market.”
Yes, both have done poorly as oil and natural gas prices fell, but with oil back up to $60 a barrel and natural gas up sharply from its lows to $8, I expect both to climb sharply through the winter. But this is an easy call for me, because Infinity Energy (IFNY) is ridiculously depressed due to the constant selling by their senior lender, which I covered in last week’s Radar Report. When the company closes the sale of its oil services operation and notifies the lender that they will be paid off from the proceeds, IFNY will take a very large jump. I like Gasco Energy (GSX) for its natural gas position in the Rocky Mountain oil shale area, but I love IFNY at this price. So, to answer your question, if I had to choose between IFNY and GSX, I’d pick IFNY. IFNY is a Top Buy up to $5 for a $9 target, and GSX is also a Top Buy up to $4.50 for a $9 target.
New World Economy MegaShift
Omniture (OMTR) was the subject of an email from Dave: “I recently purchased Omniture at $10.50. I am concerned the stock is now at about $9.50. I set a stop loss at 10% off the high, should I allow more flexibility with this stock to compensate for market adjustments or follow through with the sell order?”
That was a really tight stop loss, but if you are the kind of trader that is willing to be stopped out and then reverse direction and buy back in if the stock starts to move up, I can’t argue with it. I do not use percentage stops; I prefer to look for energy levels where money “should” come into the stock, and if it does not, then I might get out. But I will quickly get back in even at a higher price if I’ve misjudged, and the energy flows back in at a slightly lower level.
If you set a stop 10% off of $10.50, that was $9.45. If it was 10% off the high of $10.75, that was $9.68. Of course, two days after the high, our friendly market makers knocked it down to $9.55 intraday, so either you were just barely stopped out or you just barely skinned through. Either way, with the stock immediately rallying for five days to yesterday’s 52-week high at $12.45, I hope you are on board (again). OMTR remains a buy on dips under $10 for my $20 target, although I am taking it off the Top Buy list because it is trading well over the buy limit.
WiMAX MegaShift
An email from Li asked: “Regarding WiMAX, have you done the analysis of cost between the WiMAX roll out and gradually upgrading from 3G to 4G? WiMAX only has two years edge over 4G in terms of technology availability, so what makes you think a carrier will spend a fortune to develop WiMAX, instead of upgrading its network to 4G?”
Well, a couple of things. I wouldn’t use “only” and “a two-year edge” in the same phrase — that is not a trivial advantage. I also expect WiMAX equipment, built to a truly open standard, to be cheaper than 4G, which is an open standard with substantial royalty payments due to Qualcomm. Due to the lack of licensed spectrum, I expect both systems to be deployed all over the world. 4G cellular equipment will come from the same folks who build 3G equipment. WiMAX is an all-new, disruptive technology that gives three small companies, Airspan (AIRN), Alvarion (ALVR) and Terabeam (TRBM), an opportunity to become three big companies. I may recommend a 4G equipment supplier in the future, as those systems get to market, but the opportunity will never be as big as the WiMAX opportunity that’s directly in front of us.
I know the slow start to the WiMAX rollout has tried our patience so far, but this week the In-Stat market research firm published a report headlined: “WiMAX Poised For Rapid Growth Despite Major Challenges.” They said that WiMAX is entering a rapid growth phase, because service providers are now able to buy WiMAX Forum-certified equipment. There will be 222,000 subscribers worldwide at the end of 2006, and that is forecasted to grow to 19.7 million by the end of 2010. They think much of WiMAX’s early success will come from underdeveloped regions, which is a special strength for Alvarion. Alvarion had the largest share of WiMAX equipment revenue during the first half of 2006.
The In-Stat market research firm thought that Sprint would be the only U.S. carrier to deploy WiMAX in the near term, paralleling my answer to Li’s question, above.
Airspan (AIRN) reported their September quarter, which I covered in last week’s Radar Report, but there were a couple things discussed on the conference call that I want to talk about today. On the call, AIRN said that excluding their legacy proximity product, year-to-date revenues increased 127% to $72.9 million, thanks mostly to the addition of over 100 paying WiMAX customers.
The troublesome Yozan contract, which caused them to miss their targets earlier this year, seems to have been resolved. Airspan successfully completed a network optimization program that demonstrated, over a long period, network availability for both WiFi and WiMAX in excess of 99%. As a result of that, Yozan signed a services agreement for AIRN to provide ongoing network design services. In addition, Yozan agreed to take delivery of additional equipment and services, some this quarter and most in the first half of 2007. This will complete the contract, which has been reduced from $42 million to $28 million. I think this whole issue is behind AIRN, and they reduced operating expenses by 13% in the quarter to compensate for the lower than expected revenues. There will be further reductions this quarter, in order to get closer to their quarterly goal around $13 million.
The Yozan project operates in the 4.9 gigahertz spectrum, and there are over 300 license holders in that spectrum in the U.S. Airspan has technical know-how that should serve them well in this market. The company is also targeting government and military installations in the 4.9 gigahertz and 5.8 gigahertz ranges, and delivered equipment to various government agencies through a government reseller in the quarter. They have a multi-million dollar, multi-phase project with a major armed forces group through a development partnership with a major supplier of battlefield communications systems. This project includes approximately $400,000 of service revenue in the short term and $3 million of equipment revenue over the next 12 months.
AIRN raised the lower end of their annual revenue guidance range from $120 million to $125 million, keeping $130 million at the high end. That equates to fourth-quarter sales of $28 million to $33 million. They said that if a Request for Quote comes from a customer who wants to do something in the next six to nine months, it usually comes down to Airspan and Alvarion. If the customer is looking to deploy maybe two years out, then Motorola will bid, and both Alcatel and Siemens might bid.
I am trimming my buy limit on AIRN by $1 to $5, which is still well above current levels, but not changing my $10 target. I expect the stock to hit the target before the end of 2007 as the WiMAX MegaShifts into high gear.
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