I know the big picture geopolitical outlook seems complex and confusing right now, especially with the thwarted terrorist actions in the U.K. today and the ongoing fighting between Israel and Lebanon. My son is in Beirut, and has been traveling in the Becaa Valley, interviewing Hezbollah leaders and fighters. He’s been held by them several times, and a minority of them always want to kill him on the spot, yelling: “George Bush!” at him. But he has safe passage from the Lebanese military, which tells me that they are in control, at least in that part of the country.
I believe the whole conflict between Israel and Lebanon was started by Iran to divert attention from their nuclear program, and they have played their hand beautifully. A nuclear power plant runs on uranium enriched to 6%, while a nuclear bomb requires uranium enriched to at least 80%. Iran wants uranium that is enriched more than 6% but maintains that it is only using the uranium for nuclear power plants. Secretary of State Condoleezza Rice’s idea that there could be no compromise between 6% and 80% set the stage for the showdown between the United Nations and Iran. Iran will win the disagreement not by getting to enrich uranium, but by getting a huge monetary payoff from the West to not do it. And they will bank substantial extra revenues for their oil in the meantime, thanks to the higher oil prices the crises generated.
The home front political picture is also complex and confusing, but I think Joe Lieberman’s loss in the Connecticut senatorial primary does not show “division and divisiveness” in the Democratic Party, as the Republicans said. What it really showed is that a political neophyte can beat a three-term senator simply by running against President Bush’s Iraq policy. For good or ill, that message went all over the country instantly, and a lot of close races just got a lot more focused and closer. There is a very good chance Nancy Pelosi (D-CA) will be the next Speaker of the House, and an increased chance Hillary Clinton will be the next president — especially if the coming recession is deeper than what I am now expecting because the Fed feels tied to their publicly-stated 1% to 2% inflation goal. Of course, a Clinton win would set up the big economic downturn in 2010 to 2012, which I suspect is coming to complete the bear market that began in 2000.
Through all this, the MegaShifts will be the growth areas, and there will be opportunities to make substantial amounts of money. We need to stay in synch with the major market moves — down into this October, then up for two or three years, and then the big market downer leading the economy in 2009 to 2010. The capital spending surveys will be weakening over the next few months, so those who base their market calls on this lagging indicator will be turning negative and helping to create the October bottom.
Now that we are mostly through earnings season, with Cisco’s good July-quarter numbers announced after the close Tuesday — a nice bookend to Intel’s crummy June numbers announced three weeks ago — this week I want to get back to some of the fundamental drivers in our various MegaShifts, and how they should play out for the tricky second half of the year.
My stock market scenario for a weak third quarter into a spike low in mid-October still looks highly likely, followed by a powerful run up that should last for many months as the Fed reduces rates to counteract the recession. It will be an ideal environment to buy cheap stocks of companies with good growth prospects, and then get a big payoff when their fundamentals come through.
Right now, you should be holding lots of cash, nibbling at the Top Buys on down days, and thinking about what you want to own coming out of an October bottom. Of course, part of that decision depends on how low prices go, and at that time I probably will be sending Flash Alerts almost daily.
Avian Flu MegaShift
New outbreaks in people in Thailand, Indonesia and Vietnam, and an infected dead swan at the zoo in Dresden served as reminders that even in the off-season for flu, this is still a serious situation. The Thais killed 300,000 chickens after two more people died, and chicken-exporting countries are seeing their trade collapse. With bird migrations about to start again and flu season on its way by November, the whole avian flu issue will return to the front page and help push these stocks higher.
BioCryst (BCRX) reported earnings yesterday morning, and the stock dropped 18%. It was surprising, especially after they said on Monday that they received the Special Protocol Assessment that I’ve been expecting from the FDA. The Special Protocol Assessment is for Fosodine in a T-cell leukemia trial for patients who have failed at least two previous courses of treatment. BCRX will start enrollment of the 100-patient, pivotal trial by the end of the year, but it could take 18 to 24 months for enrollment. That would put final data in 2009 and FDA approval in 2010, right on schedule. But there’s also a possibility that it could enroll a little faster and get to market six months earlier.
On the conference call, BCRX disclosed that the FDA did not identify a target efficacy hurdle, which means the drug will be reviewed in context of its overall risk-to-benefit profile. That plays into Fodosine’s strengths of a very benign safety profile with proven activity. We should see several Phase II results at the American Society of Hematology (ASH) meeting December 9 to 12 in Orlando.
In regards to earnings, BCRX lost 35 cents a share for the second quarter compared to the consensus estimate of 29 cents. They are spending more on R&D and clinical trials than expected, as they see a window to get a lot of Phase I trials done before the flu season starts. They burned about $11.5 million in cash and ended the quarter with $74.7 million on the balance sheet. BCRX said that they will be increasing the burn rate to about $15 million a quarter by the end of the year.
During the conference call, management reported that they recently completed their third Phase I clinical trial of intravenous peramivir for seasonal and avian flu, which is targeted at hospitalized patients. (Intramuscular peramivir is for treating earlier-stage patients, and it is about to start its own Phase I trials.) There are about 200,000 seasonal flu patients in the U.S. every year that require hospitalization, and about 35,000 die. Intravenous peramivir would be a new treatment option for these patients, as in animal studies a single infusion knocked out both seasonal flu and bird flu.
BCRX is going to do additional Phase I studies in elderly and other subpopulations to prepare for Phase II studies during the upcoming flu season. Phase II sites will include Vietnam, Thailand and Indonesia, all hotbeds of H5N1 activity. The company will present results from all Phase I trials at the Interscience Conference on Antimicrobial Agents and Chemotherapy (ICAAC) conference from September 27 to 30 in San Francisco.
Congress recently allocated $3.8 billion to the Department of Health and Human Services to fund pandemic flu initiatives, and BioCryst requested support for these clinical development programs. I think the Department will present these awards by the end of their fiscal year on September 30, and BCRX could get up to $100 million.
And that’s not all that BioCryst is working on. By the end of the year, the company expects to file an Investigational New Drug application for BCX-4678 to start human clinical trials in hepatitis C.
It is always a danger for a biotech company to be presented with “insurmountable opportunities,” but BioCryst management seems to me to be increasing spending intelligently, in response to real clinical progress and partnering opportunities. Fear of the increased burn rate hit the stock yesterday, and while I understand the thought process, especially in a crummy market that doesn’t like small cap or biotech stocks, I think it is really misplaced in this case. As the ThinkEquity analyst said in his report today: “While the stock reacted negatively to the call’s news flow, we see no catalyst within the information provided that justifies yesterday’s sell-off. Indeed, we view the call as being incrementally positive for BioCryst, and we continue to expect a steady stream of positive news in the second half of 2006, including 1) extensive data for Fodosine at ASH in December, 2) government funding for peramivir in the third and fourth quarters of 2006 and 3) peramivir efficacy and safety data in the fourth quarter of 2006.” BCRX remains a Top Buy up to $19 for my $30 target.
Crucell (CRXL) will report results on August 29, and update us on the integration of the Berna Biotech acquisition. We should also get an update on the potential use of their cell technology in creating avian flu vaccines. Expectations are low because merger expenses are hitting the bottom line, but I think they will surprise analysts with cost reductions and guidance for more of the same. CRXL is a Top Buy up to $28 for my $50 target.
Gilead (GILD) is helping generic drug makers in India learn to copy Truvada, their very successful HIV medicine. Truvada sells in the U.S. for $24.51 a pill, and in Africa for 87 cents a pill. Gilead doesn’t want to manufacture the drug for 87 cents a dose, but they want to do what they can to help poor patients in these markets. About 6.5 million people in poor countries have HIV infections, but only 50,000 of them are taking Gilead’s drugs. By shifting the costs to the generic drug manufacturers, Gilead gives up little profit but makes up for it with a lot of goodwill. The generics will be a different shape and color than Truvada, and the manufacturers will not be allowed to export them to the developed countries.
GILD stock is doing well, and you can still get the Top Buy-rated January 2007 $60 LEAP (GDQAL) under my $9 buy limit for a $20 target in five months.
Biotech MegaShift
I mentioned in the BioCryst writeup that the market has not liked biotech stocks this year. The AMEX Biotechnology Index (BTK) is down over 17% since the end of February, and the NASDAQ Biotechnology Index (NBI) is down more than 19%. That often happens in the first half of a year, when there are fewer medical conferences and less FDA activity. Looking at the last 10 years of quarterly performance, these two biotech indices usually outperform the broad market, but they do it all in the second half of the year. In fact, biotech often leads all the industry indices in the second half of the year, especially the fourth quarter, as results are announced at conferences and the FDA scrambles to approve enough things to justify a budget increase.
The whole pattern may be accentuated this year by a confirmation of an FDA Commissioner in the next six to eight weeks, shortly after the FDA approves Barr Pharmaceuticals’ Plan B morning after contraceptive. We may also see more mergers and acquisitions in this area, as stock prices for the defensive big pharma and biotech stocks hold up relatively well in a market decline based on developing economic weakness. I expect only one blockbuster product approval in the second half, panitumumab from Amgen, but predictable, consistent earnings growth should support big pharma and big biotech stock prices.
There haven’t been any big-cap “blow ups” this year like the Vioxx disaster, but there have been some small- and mid-cap problems at companies like Neurocrine Biosciences, Pozen, Anadys, Dov Pharmaceuticals, and Inhibitex Therapeutics that have depressed the smaller stock sector. That’s an ideal set-up for more mergers, and some of our companies are definitely candidates. I think BioCryst, Dendreon, eResearch, Millennium, QLT and ViroPharma all must be on everyone’s list of prospects.
Dendreon (DNDN) reported a 26-cent per share loss yesterday morning, better than the 36-cent loss estimate, and said they are on track to finish filing their Biologics Licensing Application (BLA) for Provenge by the end of the year. But the stock barely budged on the news, as the bears, like the Brean Murray brokerage firm, continue to play the “missed their primary endpoint” tune.
I want to focus on the negative story out there so you understand the situation. Brean Murray said that they expect DNDN’s stock to continue to drift lower due to uncertainty surrounding Provenge approval. Specifically, they do not believe that DNDN will be able to submit a Provenge BLA that conclusively supports approval, given that the first two Phase III trials failed their primary endpoints. While the company is using the secondary median survival endpoint that they did meet, Brean Murray points out that this endpoint encompasses a period of time during which patient’s post-progression
treatment was highly variable. The brokerage firm thinks this is highly confounding to the analysis, especially given that 75% of the placebo patients crossed over to
Provenge upon disease progression. So, Brean Murray is recommending sale of the stock on price spikes that may be triggered by the release of data from the third Phase III PROTECT trial, if it is positive, and the announcement of completing the filing of the BLA.
I have been over this ground before, and none of these arguments are new. What Brean Murray fails to mention is that the secondary endpoint — extending median survival — is the gold standard for approval of a drug. While it is true that survival was extended by a broad range of months, the point is that some folks were helped only a little and others were helped a whole lot. The crossover of placebo patients is a red herring, as this is not a complex statistical adjustment. Perhaps the biggest factor is that the company already went over all of this in detail with the FDA staff, and was told to go ahead and file on a rolling basis to reduce the time to approval. It would have been easy for the FDA to tell Dendreon to wait until they had the PROTECT Phase III results. Instead, they told them to go ahead and file based on the first two trials’ results.
The FDA can and has done strange things before, and telling a company to file does not presume that they will approve the drug. But it does say there was enough statistical evidence about a meaningful endpoint to justify a filing. Brean Murray is entitled to their opinion, but the FDA’s actions, so far, do not support their position.
On the conference call, management said they completed the initial build-out of their New Jersey manufacturing facility to meet the clinical and potential commercial manufacturing needs for Provenge. They also completed the production of consecutive conformance lots of antigen, the key raw material used in the production of Provenge.
During the quarter they published the results of their pivotal Phase III Provenge trial in the Journal of Clinical Oncology. We have seen the numbers before:
- A median survival time four and a half months longer than the median survival seen in the placebo group.
- A 41% overall reduction in the risk of death.
- 34% of the patients receiving Provenge were alive at 36 months after treatment, compared to 11% of the patients randomized to receive the placebo.
The company lost about $19 million in the quarter and has $105.6 million in cash left, or only enough for about five or six more quarters. The BLA is on fast track review, so they should have an answer from the FDA by mid-2007, before they run out of money. I think the $300 million current market capitalization is less than their technology is worth in a takeover, because it can be applied to all solid tumor cancers and is complementary to most conventional and biotech-based approaches to cancer. But I have no illusions that we will somehow make money even if the FDA turns Provenge down — this is a speculation on one approach to cancer getting approval, which will lead to a host of approvals in other cancers over time.
The downside from current levels is minimal, and the upside is life-changing profits. So, I will make DNDN a Top Buy if it dips under $4, and I am keeping my $7 buy limit and $14 target after Provenge is approved. The PROTECT results and completed BLA filing should pop the stock, as would naming an international distribution partner, and even if Brean Murray’s customers sell into the news, we may not get a chance to buy DNDN under $4, so there is nothing wrong with buying a one-third to one-half position now, and picking up the rest when and if it becomes a Top Buy.
China MegaShift
UBS Bank published an interesting contrarian argument on China, written by their chief Asia economist. It argued that the pace of urbanization is only half the magnitude discussed in financial headlines. Instead of 250 million to 300 million “Chuppies” (Chinese urban professionals), they put the real number at 65 million to 75 million. The difference is that China labels 562 million people, or 42% of the population, as living in urban areas. But they define “urban” as huge areas that include many small villages and farming areas. For example, “cities” like Chifeng, Qiqihar, Ganzhou and Baise are larger than Maryland, Vermont or Massachusetts. UBS says the true urban population is about 244 million, or less than 19% of the population. They said: “Of all the hype and controversy surrounding the mainland economy, perhaps none is more potent than the relentless rise of the Chinese urban consumer.”
Judging by the number of Internet users, the truth probably lies somewhere between the UBS estimate and the received wisdom. If there are only 244 million urban dwellers, straight math translates to 110 million to 130 million “Chuppies,” or substantially more than the 65 million to 75 million estimated by UBS. In any case, if and when we re-enter the Internet and travel stocks we sold in May, I will use more conservative estimates for their current available market. I noticed that Ctrip (CTRP) reported a decent quarter this morning and the stock sold off anyway on valuation concerns. It is down 8.4% from where we sold it.
UTStarcom (UTSI) actually benefits from lower “Chuppie” estimates, as that means the market for those needing a cheaper wireless solution than cellular is larger than we thought. UTSI doesn’t install systems in the giant “cities” because their telecom customers need population density to make the systems profitable.
The company reported $549.1 million in sales in the June quarter, below the $558.6 million consensus. But they handily beat on the bottom line, losing only 18 cents a share instead of the 46-cent loss expected. Gross profit margins beat everyone’s estimates, including mine, as their cost reduction programs and supply chain consolidation really started to pay off.
The book-to-bill ratio was about 1.0 for the quarter, and they guided in-line for the September quarter, looking for sales of $590 million to $625 million (consensus $610 million) and a loss of 23 cents to 33 cents a share (consensus is a loss of 32 cents). The stock jumped on the better bottom line news and on management’s forecast for revenue growth in the third and fourth quarters, as well as their statement that Internet Protocol TV (IPTV) is now a major opportunity for the company.
On the conference call, they said the trend for telcos to dump their circuit-switched networks in favor of IP-based networks continues, and UTSI currently has the largest softswitch deployment in the world, supporting over 50 million subscribers. In the June quarter, they received a contract from a Tier 1 Philippines telco to build their next generation network.
In IPTV, they have a technology lead that provides far better capabilities and scalability than their competitors, and they have won over 50% of all government license IPTV deployments in China. UTSI currently has over 90% of the commercial subscribers in China on their networks. In the June quarter, they signed a follow-on deal with China Telecom to expand commercial IPTV coverage in Shanghai, a market of nearly 18 million people with two million broadband subscribers. According to the market research firm IDC, China IPTV subscribers are expected to reach 4 million in 2007 and double to 8 million by 2008 Outside of China, they are about to launch the first commercial IPTV network in Brazil with Brasil Telecom, which has almost one million broadband subscribers. UTSI’s pay IPTV trial in India continues with Bharti, a leading operator with over 1.5 million broadband subscribers.
In wireless, the PAS market should decline over time, but PAS revenues are still very important for the fixed line operators in China that are not allowed to deploy cellular systems yet. Both China Telecom and China Netcom continue to invest in expansion contracts, and in the first half of 2006, total PAS subscribers grew by six million to 92 million, of which 51 million are on UTStarcom equipment.
Outside of PAS, UTStarcom partnered with Qualcomm in the June quarter to let Qualcomm resell UTSI emergency response systems to governments in North America. UTSI is also taking market share in CDMA handsets in North America and is now the #4 supplier in the U.S. They are shipping unique handsets that are waterproof or ultra-thin to every CDMA carrier in North America. In the June quarter, they shipped a record 750,000 internally designed handsets, a triple from the 250,000 sold in the March quarter, which itself was more than the 200,000 sold in all of 2005. That’s momentum!
They had $25 million positive cash flow from operations in the quarter, and paid down $50 million in short-term debt. UTSI now expects to return to profitability in the first half of 2007. As of the end of June, they had $658 million in cash ($5.44 a share) against a varying amount of debt and credit lines. Book value was $7.52. With the stock closing today at $7.47, UTSI is a value and growth investment at the same time. I am moving the stock to a Top Buy due to the profit margin improvement, as I see little price risk even in a further market decline. I am not changing my $9 buy limit or $15 target price, but if they execute as expected and return to profitability in 2007 as planned, I will have to raise the target.
New Energy Technology MegaShift
Rentech (RTK) reported $19.7 million in sales and a 9-cent per share loss for their June third quarter. Revenues were far above the March quarter’s $2.0 million due to the April 26 acquisition of the nitrogen fertilizer plant in East Dubuque, Illinois. This plant will be converted to use the output from RTK’s clean coal-to-synthetic-fuels process that will be installed on the plant site. That will be done by the end of 2009.
The 9-cent loss was just a bit above the March quarter’s eight cents, and was better than last year’s 12-cent loss. On the conference call, management said it will take about a year to plan the two Peabody Coal clean fuels plants, with the key being 100% sequestration of carbon dioxide. Projects in Mississippi and Colorado are progressing on schedule. They ended the quarter with $65.6 million in cash. The Department of Defense is still very positive on buying synthetic fuels, and the DoD stays up to date almost daily on how Rentech is doing. RTK is an excellent buy under $5 for my $11 target.
Security MegaShift
American Science & Engineering (ASEI) reported a big revenue shortfall yesterday before the open, in spite of a building backlog and the promise of two major government orders closing as early as next week, or no later than the end of the September quarter. They were supposed to do $38 million and make 73 cents pro forma. Instead, ASEI booked only $29.9 million in sales and reported about 65 cents pro forma (41 cents under GAAP — Generally Accepted Accounting Principles).
The stock plummeted from $45.80 at Tuesday’s close to $36.27 yesterday, and then shot back up $9.37 today on the terrorist arrests in the U.K. to close at $45.64. Of course, nothing changed in the real world — the short attention span traders forgot that ASEI is the only choice for backscatter vans to detect bombs in passing cars and automated cargo inspection systems that can penetrate 14″ of solid steel.
On the conference call yesterday morning, management said that they booked a record 20 backscatter van orders from nine international clients in eight countries this quarter, which was a market they targeted to reduce the quarter-to-quarter lumpiness in orders from the U.S. They booked their third order for a $3.4 million OmniView Gantry system for container inspection at the port of Charleston, and began taking orders for the Gemini parcel inspection system that screens baggage for both organic and metallic threats. Total bookings were $25 million, with 58% from international orders.
ASEI is demonstrating the SmartCheck walk-through airport passenger screening system around the world and is waiting for the U.S. Transportation Security Administration to authorize a pilot program. When the two major government orders for backscatter vans are announced, I think they will be from the Army and the Marines, to protect bases in the Middle East and other hotspots. You may not want to chase the stock after a pop like today, but the truth is it is very cheap, and ASEI remains a buy up to $59 for a $93 target.
Gemalto (GEMP) has their tender offer open until August 14. If you are a shareholder, you should have received documents and a form to tender your Gemplus shares for stock in the new combined company. Go ahead and do it now. You will receive two shares of Gemalto for every 25 shares of Gemplus, and you will also receive a cash distribution of about 33 cents a GEMP share. Settlement will be about August 30.
The company got its first order for a U.S. electronic passport, after a long qualification process. All new or renewal passports issued from 2007 on will have a chip in them, and the U.S. issues about 10 million passports a year. News like today’s thwarted terrorist action will just accelerate the adoption of electronic passports all over the world. GEMP remains a good buy up to $6 for my $12 target.
WiMAX MegaShift
Sprint announced a $3 billion commitment to a nationwide WiMAX system. This was very good news for the industry, because Sprint already has a sophisticated cellular data network in place. The message was that WiMAX provides a different level of service from cellular data, and every other Tier 1 carrier has to look at it. Sprint gave Motorola the contract for infracture, and there is some chance Motorola will subcontract for devices from Alvarion (ALVR). Samsung received the contract for customer devices, and Intel was specified for chips.
Airspan (AIRN) reported this morning and had a long, informative conference call. They did a record $45.4 million in sales, far better than the $28.2 million consensus, and lost 19 cents a share, a bit worse than expectations for a 17-cent loss. The three most recent estimates were for a loss of 20 cents, 16 cents and 19 cents, so this wasn’t far off from real expectations. But all three of these estimates expected only $23 million to $24 million in sales, while the one analyst looking for $41 million (still low) also thought the company would lose only four cents a share. Here’s what happened.
They booked $16.8 million of sales to Yozan, their huge Japanese customer, which included $5.7 million deferred from the end of the March quarter. But Yozan renegotiated a substantially smaller agreement, and Airspan had to write off some excess inventories and pay some cancellation charges on purchase commitments, totalling about $4.4 million.
Over $17 million of their revenues were from WiMAX products shipped to more than 30 customers, including their distribution agreements with Ericsson and Nortel. Their gross profit margin on these new products is lower than they want, so they are going to reduce headcount 25%, in part by getting rid of contractors related to Yozan and consolidating supply chain efforts, and reducing other operating expenses. They will break even at $37 million in sales on a proforma basis after the restructuring is done.
For the year, AIRN now expects to do $120 million to $130 million in sales, well above the Street consensus for $117.5 million. So, they will show double-digit growth in spite of the legacy Proximity business dropping 50%, or $30 million for the year.
AIRN finished the quarter with $23.1 million in cash, including $4.7 million in restricted cash that they use to back letters of credit for their customers. This week they announced a new credit line with Silicon Valley Bank for $10 million, which will free up the $4.7 million. And they have a deal with Oak Partners (they are blue-chip VCs) to buy a $29 million preferred, subject to Airspan shareholder approval. Oak Partners now owns about 15% of the fully diluted stock and will own 33% after the new preferred is issued. Fully diluted shares will go from 47.3 million to just under 61 million. Airspan will be cash flow positive by the second quarter of 2007, even without any more business from Yozan.
Airspan also added on the conference call that they are working on a tri-band WiMAX connector that fits in the USB slot of a laptop And they have not seen any disruption at their Israeli R&D facility to date, which is next to the Tel Aviv airport, but they have had six of their 110 employees called up for military service. Their products are built by Flextronix in a facility only seven miles south of Hiafa, and about 10% of Flextronix’ work force have been recruited for duty. So, AIRN has started the process of moving production to a different Felxtronix facility somewhere else in the world.
Both Wall Street and I liked the conference call and the revenue forecast, which moved the stock up 13 cents today. It is still very cheap, and AIRN can be bought up to $6 for my $10 target.
MobilePro (MOBL) reported today, and while the top line looked good, their costs were a little high. I will analyze the 10-Q and give you a full report next week, but I don’t see anything that would change my recommendation to buy MOBL up to 25 cents for a 60-cent target.
Google Short Sale
It looks like we set the stop-loss on the Google (GOOG) short sale just right at $385, as the stock hit $384.68 at yesterday’s open before plunging to close at $374.20 today. As investors worry about a sharp drop in advertising in a recession, I expect GOOG to lead the market to the downside. Short GOOG over $350 for a $200 target in mid-October. The December $370 put contract (GGDXN) or the December $380 put contract (GOPXP) are good alternatives if you don’t want to take the risks of a short sale, or if you want to do this in a retirement account that can’t short.
Market Outlook
Wasn’t this pause supposed to refresh? The odds of a pause grew rapidly after Chairman Bernanke’s dovish testimony to Congress in late July. But the important factor was the six-week rally in the bond market, which dropped long-term yields well below short-term yields — the inverted yield curve.
Why would the bond vigilantes rally bonds if the Fed is not going to fight inflation? Because they see a hard landing coming for the economy. In fact, that is exactly why an inverted yield curve usually forecasts a recession. The folks who set bond yields see it coming.
The pressures are easy to spot: High energy prices are crimping consumer budgets, and the housing market is now sliding into the tank. The California Realtors Association, a cheerleading group if there ever was one, expected a 2% drop in housing sales in 2006, but they just revised that to a 16.8% drop. The CEO of D.R. Horton, the largest U.S. homebuilder, said that in June his company’s national sales “fell off the Richter scale.” I think he mixed a couple of metaphors there, but you get the idea. In May, AmeriQuest, the largest U.S. mortgage lending company, announced that they were laying off 3,800 employees — a third of their work force — and closing all 229 of their retail branches. Yesterday, Toll Brothers, the largest luxury home builder, reported its first year-over-year revenue decline in four years and cut their December-quarter outlook. Countrywide Financial reported that mortgage lending dropped 19% in July from the same month last year, and the CEO said: “I’ve never seen a soft landing in 53 years.”
I expect the economic news to continue to get worse, but it won’t slow down inflation any time soon. As I’ve noted before, inflation is a lagging indicator, and Tuesday’s announcement that unit labor costs increased 4.2% in the June quarter marked the largest increase since the end of 2004. It was a dramatic increase from the 2.5% recorded in the March quarter, which was double the 1.2% expected at that time.
As an object lesson in how these numbers are either unreliable or manipulated (take your pick), the 2.5% increase reported on May 4 was one of the factors that caused the market to peak the next day, as investors feared more Fed increases to ward off inflation. But that March-quarter number was revised down to 1.6% on June 1, “easing concerns that rising wages will fuel inflation.” Bloomberg reported that: “Greater efficiency is helping businesses control labor costs, allowing them to withstand surging raw-materials prices without resorting to large price increases. Smaller labor-cost gains will come as a relief to the Federal Reserve policy makers concerned about inflation and may tip the balance in favor of holding interest rates steady at the Fed’s next meeting.” The S&P obligingly rallied 20 points in two days.
Then, in Tuesday’s announcement that June-quarter labor costs shot up 4.2%, they quietly raised the March-quarter figure back to 2.5%. Whether we should mutter “bozo alert” or “mission accomplished” I don’t know, but I do know it illustrates one of the reasons why we focus on making money over one- to three-year holding periods. The very short term is just random noise.
The big picture here is that the Fed wants the economy to grow substantially less than 3% in order to keep energy costs from seeping into wage rates, and from there into product prices. By pausing, they put pressure on the dollar because other countries are increasing rates, and a lower dollar creates more inflation by raising the price of imported goods. So, while they don’t want housing to crash or oil to go to $100 a barrel, those two forces will play into their hands if they put a good-sized crimp in consumer spending. That’s the big picture I am watching, and we should start seeing estimate cuts in the consumer sectors shortly to confirm it. The crash in the economically-sensitive Dow Jones Transportation Index, which fell 125 points yesterday but gained back 52 points today, and is down 15% from July 3, is an early signal the market is rapidly swinging to my view that a mild recession will start as early as the December quarter.
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