Today’s Radar Report is probably the most important one I’ve sent in the last 18 months. We are approaching a critical point and time for the equity markets, and the pattern is not yet playing out as I had expected. Although the market will have the final say, I don’t think I was “wrong” — I think I was early. In this issue, I want to tell you what you should expect for the rest of 2006, how that affects my outlook for 2007 and what is in store for us through 2011. So, let’s jump right in and start with the shorter-term picture.
The Shorter-Term Outlook
I’ve recommended high levels of cash through the hurricane season, but the forecasters were completely wrong in calling for a worse-than-normal year. So far, it has been far better than normal.
I’ve also been leery of the seasonal weakness in September and October, but we just closed September with a 2.5% gain in the S&P 500 — the best month since January.
Sliding oil prices and optimism that the Fed is done raising rates overcame slowing GDP and housing fears to make it a good month.
However, my projection for a downturn in the fourth quarter of 2006 may simply be delayed rather than cancelled. What it comes down to is that the falling price of oil has been a big driver for this market — and it may be over. My projection has been for a bottom at $57 to $58 a barrel. The November futures hit $57.80 yesterday morning, before OPEC leaked a rumor that they might take a million barrels a day out of production at their next meeting. Translation: Don’t knock oil down any further, traders, or we will burn your shorts. With OPEC guaranteeing the downside, oil prices rebounded sharply to just under $60. It would be normal to see prices retest that $57 to $58 range shortly, and then head up to probe the resistance at $68. The process of adding $10 a barrel to oil prices might prove to be pretty unnerving to the stock market.
For the very short term, though, low oil prices and good September-quarter earnings should provide enough enthusiasm for traders to push the S&P 500 up to 1365. However that is the major monthly breakdown level from the January 2001 mini-rally that previously signaled that a serious bear market was underway. It is very typical for markets to rally all the way back to significant breakdown levels and then “kiss them goodbye” into a final plunge.
On the other hand, if the S&P can decisively break through 1365, then the August 2000 high of 1518, and maybe even the all-time high of 1553, become the next targets. If this happens, which to me is highly unlikely, I will put my bearish outlook into the dustbin.
The fundamentals underlying my outlook are my belief that investors are making a similar mistake to the one they made in early 2000. Then, stocks traded on an assumption that the Fed, personified by Alan Greenspan, could avoid recessions while technology earnings grew 30% a year forever, thus justifying what looked like very high P/E ratios. Now, stocks are trading on an assumption that the Fed can engineer a soft landing, avoiding both inflation and a recession, so corporate profit margins will stay at record levels, allowing price/earnings ratios — which look cheap based on projected earnings — to expand further, pushing stocks higher. There is no allowance for the fact that profit margins will revert to normal levels in a downturn.
Also, both then and now, the final moves up show deteriorating market internals, such as increasing divergences across industry groups, poor breadth and slowing or non-confirming volume. The rally in big-cap stocks has carried the market, and even that has been deceptively narrow. As of last Thursday’s close, when the Dow Jones Industrial Average set a 2006 high just a few points away from a new all-time high, not one of the 30 components rose to a new all-time high. An astonishing 19 stocks — 63% of the Index — showed losses of 20% or more from their individual all-time highs, and 13 of those (43%) showed losses of 40% or more. In the broader market, at last Thursday’s peak, less than 6% of domestic common stocks rose to new 52-week highs, while almost 27% already show losses of 20% or more over the last year. This kind of narrow selectivity typically marks major market tops, and major market drops often happen within the six-month window preceding a recession. We are probably in that window now.
Outlook for 2007 and 2008
No one wants to hear this but I expect that the economy will be weak in 2007, especially in the first half of the year. However, I don’t want you to get discouraged before you even start, because 2007 will also be an unbelievable entry point to buy stocks that can fuel your portfolios into retirement.
History shows that during periods when the GDP and corporate earnings are growing rapidly, stock prices often do poorly. That’s because the market is looking ahead to what they know is coming: The Fed tightening monetary policy, raw materials prices and wages accelerating, and inflation picking up. In contrast, when the economy is soft and corporate earnings are disappointing, which I think will characterize 2007, the market starts looking ahead to Fed interest-rate cuts and improving profit margins. So, stock prices do better.
There are three things that I think will ultimately affect the markets in 2007: housing, consumer spending and business capital spending.
Just as housing tends to lead the economy down, as it has been doing since June 2005, housing also usually leads the economy up after the Fed cuts interest rates. So one of the keys to my outlook is when the Fed will cut rates. I think it will be sooner rather than later, even though the inflation numbers will stay above the Fed’s “comfort level” for most of the year. Inflation has been above their comfort level since March 2004, so I take “comfort level” to be a meaningless phrase in terms of actually impacting Fed policy. The Fed will respond to weakening GDP and a possible recession with both interest rate cuts (the price of money) and high monetary growth (the volume of money).
Consumer spending, overall, will be subdued this holiday season and into 2007, but I expect a significant shift towards spending on consumer electronics for holiday gift giving. Following that, the very large personal computer cycle that will be driven by Windows Vista, Intel Quad-Core processors and WiMAX will get underway sometime between January and May, depending on when Microsoft really ships Vista.
Business capital spending will be weak in 2007, because budgets will be established during the weak December 2006 quarter. However, there are some “must spend” areas like video on demand, WiMAX, 3G cellular and broadband over power lines that will continue to get funding for competitive reasons.
Also, as you probably already know, 2007 marks the third year of the Presidential cycle. And typically, the third year often follows a recessionary second year and can provide some spectacular stock market gains. But this time, the mild recession or near-recession will be happening early in the third year instead of in the second year, and the stock market has not yet acknowledged that risk by dropping below its mid-2006 lows. Major gains will likely wait until the second half of 2007, when we see the Fed start cutting interest rates and improving housing and consumer spending numbers are on the horizon. Of course, a sharp market drop in the next several weeks could provide the launching pad for the typical 50% broad market gain in the third year.
In either case, 2008 will be the fourth year of the Presidential term, and will bring the usual fiscal stimulus and steady monetary policy that causes a good year in both the economy and the stock market. I expect most of the MegaShift stocks that we now hold to set multiyear highs in 2008 and early 2009. The path after that will depend on who wins the 2008 Presidential election and many other current unknowns, but the longer-term fractal market projections are pretty dismal for 2009 to 2011, with another major bottom in the area of the 2001 and 2002 bottoms — or worse.
The Bottom Line
I forecast the weakening economy and collapsing housing market long before most other prognosticators, and turned negative on the stock market in February. There’s been little progress in most market averages since then, and actual downturns in most stocks and sectors, but the broad market has not cracked yet to reflect the oncoming weakness. After the December 2000 quarter, I am not willing to assume that strong seasonal factors can make up for complacent investors in a weakening economy, so I am not ready to sound the all-clear signal yet.
Even if we are in a Goldilocks market that is eventually going to extend to new highs above 1560, it is still very likely the S& P 500 will hit huge resistance at 1365. It would be normal to correct back down to 1327, or perhaps all the way back to 1292, even in an ongoing uptrend.
If the S&P 500 can vault through the major resistance at 1365, I will raise some buy limits and recommend going 100% invested. But I think the big risk is that the S&P 500 will fail at 1365, drop through the recent support level at 1327, and then crack 1295 to head back to the 2006 lows around 1220, or even all the way down to 1140. We would use that downturn as a major buying opportunity for the next two years.
I’m not going to try to make money on that quick decline even if it happens, but I know some of you are short-term traders and others would feel better with some portfolio protection in place. Subscriber Michael asked: “I ‘m getting several reports also predicting a massive downward correction shortly and are advising we protect ourselves with purchasing puts of certain indexes? What is your position on that and exactly which puts would you recommend?”
It is usually best to buy puts with a strike price near the current price, but a term much longer than you expect any problems to occur. Otherwise, you can get badly hurt as the time premium decays, even if you turn out to be right on the direction. You also need liquidity, as the options market is the last refuge of the fixed-spread scoundrels, who are buying options at 40 cents and selling them at 50 cents in the next trade. So I would stick with put options on either the Nasdaq QQQQ or the S&P 500 SPY.
Today, on the QQQQ that would mean buying the January $40 put (QQQ MN), and on the SPY you would have to go out to March to buy the $133 put (SFB OC). After they list January SPY options in mid-October, you could sell the March contracts and buy the January contract.
For those who have similar concerns but can’t or don’t want to trade options, there are mutual funds that goes up twice as fast as the NASDAQ 100 goes down, and vice-versa. One is the ProFunds UltraShort OTC ProFund (USPIX).
For the portion of your investments that you keep in stocks, the MegaShifts least likely to be affected by a brief down market are Avian Flu, Biotech, New Energy Technology and WiMAX.
Avian Flu MegaShift
Indonesia is the fourth-most populous country in the world, and its citizens raise about 300 million backyard fowl, including right in the capital city of Jakarta. Most Indonesians don’t keep dogs as pets for religious reasons, but 80% of the 55 million households keep everything from ordinary chickens to exotic pet birds. The country’s Director of Animal Health now thinks as many as 27% of the birds are infected with the H5N1 bird flu virus, which accounts for the country’s leading position in flu-caused deaths so far this year. The good news is that a recent analysis of tissue samples from birds in many areas showed that the virus has not mutated much over the last year.
But the prevailing attitude in Indonesia is summed up by a 39-year-old janitor named Setyabudi, who said; “Why should we be afraid of bird flu? People die because it is God’s will.”
That attitude combined with inadequate funding means the problem is only going to get worse. Indonesia will only spend $54.4 million this year on bird flu control, while world organizations think a $250 million program is needed. Their budget for next year shows a decline of 15% to $46.5 million.
I know I harp on Indonesia, but that’s because it is the most likely place for H5N1 to mutate to a form that can be transmitted from human to human by sneezing and coughing. The new case in China this week reminds us that there are many other contenders for this dubious honor, but Indonesia remains the prime focus. With the fall migration season underway, I expect the lethal form of H5N1 to be found in the U.S. before the end of the year. (The H5N1 found last week in teal ducks in Illinois is the same low-level form found earlier this year in birds in Michigan, Maryland and Montana.)
BioCryst (BCRX) announced positive Phase I data for peramivir at all dose levels in both intramuscular and intravenous trials. I expected this, and the company will press on with Phase II trials during the coming flu season. Remember that successful Phase II trials can lead to early FDA approval under the BioShield legislation.
In a “you-gotta-be-kidding” moment, the stock dropped about $1.50 on these results. There was no reason for it. BCRX is a Top Buy all the way up to $19 for my $30 target, which I expect when peramivir is approved for government stockpiling for avian flu next year.
Gilead Sciences (GILD) was hit for $4.50 on Monday and another $2.25 on Tuesday after they announced the acquisition of Myogen (MYOG) for $2.5 billion. The deal gives Gilead two hypertension drugs — one about to file for approval and one potential blockbuster in Phase III clinical trials — but the acquisition will dilute earnings about 8% in 2007 and 2008. It will add $300 million to $500 million in sales in 2009 and 2010, and most Street analysts are raising their growth estimates for GILD now that they know what the new product pipeline will be.
The stock has stabilized because the deal makes tremendous business sense for Gilead, and also means they probably won’t do another dilutive deal in the next 12 to 18 months. However, they did pay a high price and this did not further their avian flu portfolio, which is the main reason why we own the stock.
Of our two LEAP option recommendations, I’ve liked the January 2008 $50 call (YGDAJ) best, but it never seems to trade under the $16 buy limit. It hit $24 last Friday, on its way to my $30 target, before this announcement. It closed at $19.70 today. I don’t think we need to change anything here unless the market heads up further, in which case I might raise the buy limit to $20. Continue to buy YGD AJ on any dips under $16 for my $30 target.
The January 2007 $60 call’s (GDQAL) time premium is about to start vanishing. That’s the risk. The reward is that any negative news on bird flu will jump GILD and possibly skyrocket this option. So I want to stick with it for a while, changing the buy limit on GDQ AL to a Hold, and leaving the target at $20.
Biotech MegaShift
eResearch (ERES) was the subject of an email from Alan: “Would you please comment upon the status of eResearch in the next Radar Report. Their appearance at the UBS Global Healthcare Services Conference on Sept. 25th did not seem to do anything for the stock price and it has certainly been languishing for some time.”
Quite true on all counts. As you know, eResearch’s orders have been stronger and stronger for three quarters, and probably were up again in the September quarter. But the lag time to start the trials has been disappointing, and therefore the company keeps missing their revenue guidance, so the stock is mired at $8.
Revenues for the March and June quarters hit $21.4 million and $22.8 million, respectively, a total of $44.2 million for the first half. They guided for $92 million to $96 million for the year, which means $47.8 million to $51.8 million for the second half. That’s very modest growth, and quarterly revenues would be tracking far below orders. So, either companies are ordering much further ahead of need than they used to, or ERES is unable to scale up fast enough to keep their backlog from climbing, or they are low-balling us. I suspect the latter.
Wall Street is looking for only $23.5 million in sales for the September quarter, in a range of $22.3 million to $24.4 million, with four cents to six cents a share in earnings. I am expecting $24.2 million and six or seven cents. For the December quarter, Wall Street is at $25.9 million, in a range from $24.0 million to $27.4 million. The consensus earnings estimate is eight cents a share, in a range from five to ten cents. I think the company will guide for $27.5 million and nine to ten cents a share, bringing them in at the top of their current guidance range for the second half ERES should also say something about continued growth from there, based on the backlog.
All that will get the stock moving again, and ERES remains a Top Buy all the way up to $16 for my $30 target.
New Energy Technology MegaShift
I said above that I expect a near-term drop in oil prices to the $57 to $58 per barrel range, and the drop so far clearly is impacting all energy and alternative energy stocks. I want to make it clear that $57 to $58 looks like a major bottom to me, and we will be up and away from there as cold weather hits and the geopolitical risks play out. Of course, it is just “trader stuff” to mark down an alternative energy stock just because the current price of oil falls. There are many underlying issues over the next several years that will push alternative energy stocks higher, including shrinking supplies of conventional oil, still-rapidly increasing demand in China and India, and the need for politically secure sources of energy. Canadian tar sands, oil shale, coal-to-liquids, wind-power and wave-power can generate electricity at the equivalent of about $35 to $45 per barrel of oil, and solar is competitive without subsidies at $60 to $70 a barrel. None of these are going to go away just because oil drops to $57 for a week or two.
Natural gas prices also headed higher for the fifth day in a row as traders shifted their focus to the coming colder weather. With a developing El Niño off the California coast, it could be a very cold winter in the Northeast this year. That’s good news for Gasco Energy (GSX), which announced third-quarter net natural gas production today from its Utah and Wyoming projects, in oil shale territory. Production hit 944.7 million cubic feet equivalent, up 10% from the June quarter and up 93% from last year’s period. This was an excellent number.
Subscriber Jacob emailed: “Hey, Michael, I was wondering if the recent buyout by GSX will push back your time frame on the future $9 price. I am very impressed with GSX but I don’t know if I want to jump in just yet.”
Just the opposite, Jacob. Their buyout of their production partner, Brek Energy, will add to earnings even at current low natural gas prices. If you want to own it, the stock has started moving up and now is the time to load up on Top Buy GSX under $4.50, for my $9 target.
Fuel Cell Energy (FCEL) will benefit from California’s extension of the Self-Generation Incentive Program from 2008 to 2012. The extension was signed by the Governator late last week. That program is providing $1.9 million for a new FCEL contract with an unnamed hospitality and entertainment resort — Fuel Cell’s third hotel site in California. The customer will install the system themselves to save money, a move that Fuel Cell encourages, as they designed their system to be easily-installed. It will be ready in April 2007, when the customer will be named. The little birdies are whispering: “Disneyland.” Buy FCEL up to $11 for my $22 target.
Infinity Energy (IFNY) is having great operating results and cash constraints that may lead to a sale of the company — at higher prices, of course. The operating results included a record $11 million in oilfield service revenues, more than the previous guidance and 18% ahead of the June quarter. That operation is for sale, with the proceeds anticipated to be enough to pay off all their debt. On the production side, they hit their previous guidance for a record 5.3 million cubic feet equivalent of natural gas as a daily average, up 15% from the June quarter.
But they are low on cash, so they let their rented drilling rig go instead of restarting their drilling program this quarter. They also renegotiated their debt to a January 15 due date with no cash outlays, and IFNY said on the conference call that they are looking at all the alternatives, including a sale of the whole company. The falling price of oil certainly slowed down their spin-off of the oilfield services operation, but they have had expressions of interest from buyers for that and for the whole company.
The best outcome for us would be a sale of oilfield services so that they can pay off the debt and get a new bank line to start drilling again. Second would be a partner on their South American offshore leases. I really hope they don’t have to sell the whole company, although I expect any such transaction would be at substantially higher prices than today.
Because I think oil has bottomed, I am comfortable sticking with IFNY. My sum-of-the-parts analysis is that this stock should be at $14, not $4. I am not willing to take it off the Top Buy list or reduce the modest target price, but I will trim the buy limit from $6.50 to $5 just to reflect the uncertainty Buy IFNY under $5 for my $9 target, even if we have to get there by seeing the company broken up and sold in pieces.
WiMAX MegaShift
Alvarion (ALVR) made an important product announcement of the BreezeMAX 2300 and 2500 products for fixed and mobile WiMAX in the 2.3 gigahertz and 2.5 gigahertz bands used in North America. This product was designed from the ground up to the mobile WiMAX standard (802.16e), as opposed to being a modified older product. It is aimed right at the heart of the Sprint Nextel-type deployment, which means any potential competitor has to take a look at it.
Subscriber Michael asked a good question about Alvarion: “Why is it that with only positive news coming out periodically, ALVR goes nowhere but down?”
I know it seems that way, because I often ask myself the same thing. The easy answer is that Wall Street is waiting for them to have a breakeven or better quarter. The last five quarters of small losses, while we waited for the WiMAX certifiers to do their job, proved to be too long for the Street to wait, especially with the Israel/Lebanon conflict. Expectations for the September-quarter range from minus a penny to plus a penny, so ALVR has the opportunity to surprise a bit to the upside and report good orders to drive a good December quarter.
But the truth is the stock price already turned. ALVR was trading around $6.25 in June, before the July swoon and the conflict dragged it down to $5. But a ThinkEquity buy recommendation in early August pushed it up over $7, and now it has settled back to a tight range with good support at $6.25 and, so far, resistance at $6.75. We’ll take out that resistance level on the next move up, and then see how the stock does at the following overhang point at $7.25. I think with the WiMAX rollout accelerating, thanks to Sprint, this will be one of the hot industries and hot stocks in the next market up leg. So, ALVR is still a Top Buy up to $9 for an $18 target.
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