The economy continues to downshift to a rate of growth below potential output while inflation remains troublesomely high.  With a stagflation scenario now squarely in the realm of possibility and the world’s fleet of gas guzzlers caught in a prolonged oil price shock, U.S. stock markets continue in a clear downtrend – as does consumer confidence.   Adding to the market’s uncertainty, we’ve got a hot war in Lebanon and a noticeable rise in terrorist activity.  As the great philosopher Mile’s Davis once opined: “Bitches Brew”

More broadly, it is increasingly clear that, on the chessboard of life and foreign policy, the Bush-Rumsfeld-Cheney team has clearly been playing checkers.  Their Iraq adventure – privately discouraged by both Colin Powell and then-Treasury Secretary Paul O’Neill -- represents the greatest miscalculation in American foreign policy history, far eclipsing the Democrat’s Vietnam gambit.  Consider that in Vietnam no “dominos” ever fell.  That is, no other countries in the region went over to the Red side after the fall of Saigon, and Vietnam is now positioned as one of the leading launching pads in Asia for capitalist/entrepreneurial activity.

In contrast, the Iraq adventure has already led to a significant strengthening of the budding Iranian Shiite empire.  Indeed once the U.S. pulls the plug on Iraq, the Shiite portion of Iraq – more than half of the country’s population -- will become nothing more than a puppet state of Iran controlled by Iranian mullahs.

Meanwhile, the Iranian/Shiite forces will begin to challenge all of the Sunni states, including Egypt, Jordan, and, most ominously, Saudi Arabia.  My worst oil fear, by the way, is for the Saudi’s to succumb to a fundamentalist revolution engineered by either Iran or Osama.  If the oil in Iran, Iraq and Saudi Arabia is controlled by Muslim fundamentalists, oil will hit $200 a barrel or more and we will all be bicycling to work.  The sad part here is that Bush and Rumsfeld and the Dark Prince have pushed us closer to that possibility – and please, my Republican readers, this is a non-partisan statement, not an indictment of the party.

This Week’s Market Movers – Ironies Abound
Last week, the Fed called a halt to raising interest rates, but it’s moves were overshadowed by exogenous events, namely the latest terrorist plot that was foiled.  This week, a likely market mover will be the producer price index on Tuesday.  Any signs of inflation will be bearish.

Other reports of interest will include housing starts and industrial production on Wednesday, and consumer sentiment on Friday – all an all a pretty tame week.  In the dead of August and with little on the calendar to move the markets, look for low volatility and low volume and a meek market.

Portfolio Shorts and Longs 
At this point, I’m holding five stocks, all on the long side – and all with the market in a clear downtrend.  There’s at least a bit of method to my madness.

Three of the stocks are biotechs and arguably outside the business cycle’s ups and downs.  Abaxis (ABAX) makes portable blood analysis systems and went on a tear a week or so ago.  I’m scaling in, I’m slightly in the red on this one, but not particularly worried yet.  EPIX and AXCA are Vaino biotech corner picks – and EPIX is behaving particularly well as a long term buy and hold.

I also opened a positing in Ansoft (ANST) based on a Market Edge recommendation.  It a design software maker used by engineers in the cell phone, internet networking, and satellite communications spaces, to name a few.  I see this stock more as riding the wave of innovation that the business cycle. 

Lastly, there is the Brazilian ETF EWZ.  I’m down a point on a $40 stock with a very small position but want to have my toe in these waters to see if the Asian-Latin American economies are going to go gangbusters even if the U.S. fades a bit.  Good chance they may.

Now let’s turn to Andrew Vaino, who revisits a stock I’ve been watching very carefully ever since his first recommendation.

Vaino’s Biotech Corner: Making ethanol is just good chemistry

My advice on Diversa (DVSA) back in March was to buy and then sell in advance of Q2 and Q3 earnings.  I did this myself and was really quite happy with the undulations of this stock.  The stock, which was hovering above $10 for a while, is back down to less than $9.  I think maybe this is a stock worth buying again.

What I liked about Diversa back in March was their “Ultra-Thin” enzyme.  This enzyme makes it easier for industrial plants to convert the starch in corn into simple sugars which are then fermented to ethanol.  The advantage of Diversa’s product is that it allows the manufacturing plants to use more extreme conditions and produce ethanol more efficiently.

An article in last week’s Barron’s on ethanol for fuel rekindled my interest in Diversa.  In particular, the article noted that US consumption of fuel ethanol could hit 8 billion barrels this year, double what it was last year.  In an article in the August 9th Kearney (Nebraska) Hub, Congressman Tom Osborne said he “is a bit concerned at the rate in which (ethanol) production plants are popping up across the state.”  He further went on to say, “one of my fears is that we don’t keep up with bioscience”.  I’ll drink to that.  According to the Nebraska Ethanol Energy Board, there are plans to build 23 ethanol plants in the state.  Twelve plants are currently running.  That’s a pretty significant increase in capacity.

Oil prices dropped after events in the UK on Thursday.  It’s clear to me the expectation of decreased demand that may have caused this drop was irrational.  The decrease in supply, however, from the closure of much of BP’s Alaskan oil field is very rational.  It will be interesting to see just how many pipes they need to replace.  Bottom line, oil prices aren’t going down anytime soon, making fuel from ethanol more attractive. 

So here’s where it gets interesting.  Since January, the price of a barrel of ethanol has increased from $2.00 to $3.80.  The price of a bushel of corn has gone up from $1.87 in March to $2.40.  A dry summer in the Midwest is creating concern that the price of corn could increase further.  So, if ethanol plants can use corn more efficiently their margins will increase.  That’s why I think demand for Ultra-Thin will grow stronger.

Through their partner, Valley Research, Ultra-Thin has been tested in ten plants to date, and more efficient throughput of corn has been seen.  Another ten of these “plant trials” are expected to be done this year. 

Now, technically DVSA isn’t a buy, but the charts show signs of improvement.  And, to be clear, Ultra-Thin so far hasn’t lived up to Diversa’s expectations.  In their March earnings call, they were predicting $20M in sales for this year and said they thought they would be profitable in 2007.  In their earnings call on August 3rd they were figuring sales for Ultra-Thin would probably be less than $5M for the year.  They also pushed back their expectation of profitability until 2008. 

My take is their predictions were overly ambitious, but that they still have a good product.  Once they’re able to run some more “plant trials” hopefully they will demonstrate Ultra-Thin’s advantages, and sales with explode like an Appalachian still. 

Peter Navarro is a business professor at the University of California-Irvine, and can be contacted at pn@peternavarro.com. Matt Davio is a managing partner at the hedge fund, Red Rock Capital Fund, and be contacted for hedge fund services at redrock@peternavarro.com.  Andrew Vaino is a Ph.D. chemist currently teaching at The University of Maine.

DISCLAIMER: This newsletter is written for educational purposes only.  By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever.  Trading and investing involves high levels of risk.  The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader.  The authors may or may not have positions in the financial instruments discussed in this newsletter.  Future results can be dramatically different from the opinions expressed herein.  Past performance does not guarantee future performance.