Navarro’s Big Economic Picture

A free fall in oil prices coupled with Friday's benign CPI report boosted stocks last week as most of the major averages got back their previous week's losses.  Year-to-date, the Dow is up 7.9% while the NASDAQ has gained 1.4%. Trading the DJIA (DIA) using a buy/hold strategy has produced a gain of 843 points (+7.9%) while utilizing the Market Edge long/short approach would have generated a loss of 200 points (-1.9%). [emphasis added]

Market Edge Weekly Market Comment
This quote from one of my favorite technical analysis sites pretty much sums up the sorry state of market affairs for would-be traders.  On the one hand, we’ve got a market that continues to make bullish feints and creep up to multi-month highs.  On the other hand, pure technical traders are getting hammered trying to play a market where both volume and volatility are largely missing in action.

What is most puzzling to me in this particular time frame is the “free fall in oil prices” and clear downward trend in energy stocks.  Yes, it is a free fall and downtrend consistent with a sector rotation out of energy at the late stages of an economic expansion moving into recession or slowdown.  But the signs of that slowdown aren’t as apparent as one might think.  Indeed, the ECRI Weekly Leading Index was up again this week, for the fourth week in a row.  Here’s some more analysis from dismalscience.com that you may find interesting:

The price of a barrel of the benchmark West Texas Intermediate crude oil has fallen more than $12 over the past two weeks. [This] sharp drop in prices in such a short period of time has turned sentiment around 180 degrees: rather than fearing high prices, interest now centers on how low prices are likely to fall. We expect oil prices to average between $60 and $65 for the rest of 2006.

…We believe that the $12 drop in oil prices over the past few weeks reflects an unwinding of a significant portion of the speculative pressures in oil markets. This process began with the cessation of military hostilities in Lebanon, which had added $3 to $4 to the price of a barrel of oil. Then came the passing without incident of the August 31 U.N. ultimatum to Iran, which has finally allowed traders to believe that the risk of an actual oil supply cut from that country…is increasingly remote. Finally, the lack of any major hurricane-related Gulf Coast disruptions this far into the hurricane season is also taking out some of the speculative pressure that had been built into the market.

In addition to the deflating of some of the speculative factors that had been driving up oil prices, increasing fear of a slowdown in global demand, led by the coming slowdown in the U.S. economy, has also fed some of the recent price decline. Finally, news of the commercial viability of a large new reserve of oil in the Gulf of Mexico is also influencing oil markets…”  [Regarding global demand], the euro zone economy posted its highest growth in six years on the back of solid performances in Germany and France, somewhat negating the slack in the U.S. Strong performance in Asian and Latin American countries in the second quarter also helped limit the negative impact of the weaker U.S. economy.”

And check out this picture.  It’s a pretty robust snapshot of a world that may survive a U.S. slowdown.

China and India are both on a tear.  But the good news is that even Germany and France have gotten off the deck.

This Week’s Market Movers
There are two likely big market movers next week.  The producer price index flies on Tuesday and anything deviating from consensus will send the markets up (on benign inflation) or down (or unexpected inflation).  The next day, the Fed meets and will decide on a continuation of its current rate hike pause or the application of some more pressure.  Obviously, another rate hike would be bearish.  New home construction on Tuesday will likewise be of some interest, as an ongoing monitoring of the fate of the housing bubble is crucial to a longer term expansion.

Portfolio Shorts and Longs 
I have two stocks to feature this week.  Both are in sectors showing considerable technical strength and both are in sectors that are smiled on favorably in a sector rotation strategy in which the economy begins to cool.  One of the stocks is Tenet Health Care (THC).   The other stock is Rite Aid (RAD).  Both are pure technical plays as for each, fundamentals leave a bit to be desired.  But in each case, the price seems right, with the risk to reward favoring the long side.

Vaino’s Biotech Corner: Some Nice Shorts for Indian Summer

With the weather reports here in Maine warning of frost for the weekend, I thought this might be a good time to get out in some shorts before it gets too cold.   I am baffled that Alnylam Pharmaceuticals (ALNY) is trading as high as it is.  The stock is trading at $14, giving a market cap of $450M.  I am at a loss to understand how a company whose product pipeline comprises a single drug in a Phase 1 study (Phase 1!) can be valued so highly.  To be clear, I am familiar with the idea that a stock’s price represents the market’s expectation of future earnings divided by risk, but I think this is way out of balance.

The science behind Alnylam’s drug (and future drugs) is pretty cool.  It’s a technology called RNAi (short for RNA interference).  In the body, RNA acts as an intermediary in the synthesis of proteins directed by DNA.  Now, most diseases stem from the generation or misregulation of a protein.  So, being able to shut down a specific protein has the potential to afford a safe treatment for, theoretically, almost any disease.  It is really a cool idea.

Alnylam was founded in 2002 and can in some ways be considered a spin-off of Isis Pharmaceuticals (ISIS).  They licensed about 75% of their patents from Isis.  Isis’ technology is based on so-called “anti-sense” therapy.  From a chemical point of view, I really don’t see any difference between RNAi and anti-sense.  The compounds themselves are analogous, and the idea is the same:  basically mess with RNA before it can make proteins.

I like Isis as an instrument company (recall their “Tiger” technology), but not so much as a drug company.  Their only success in getting a drug to market has been with Vitravene, a treatment for CMV retinitis.  Isis does not report sales for Vitravene in their recent 10Ks, and states that it’s “distributed on a limited basis” due to a decline in the incidence of the disease.

What has hampered Isis’ drug development efforts has been pharmacokinetics, that is, the reactions drugs undergo in the body.  These anti-sense, or RNAi, drugs get degraded rapidly.  In fact, degradation of Vitravene is so fast it has to be injected directly into the eye.  Ouch. 

Now, new technology has been created that stabilizes RNA, , for example short hairpin RNA (shRNA) ---which was what has hampered Isis.  Alynlam has completed a Phase 1 clinical trial whose intent was, according to their April 30 press release, “… to evaluate the safety, tolerability, and pharmacokinetics of ALN-RSV01 in healthy adult volunteers”.  In a subsequent press release the drug was reported to be safe.  There was no mention made about the big issue here, that is pharmacokinetics.  This makes me suspicious.  I tried contacting Alnylam seeking clarification on Wednesday, and still have not heard back.

A Phase 2 study is planned for the first half of 2007: this delay also makes me suspicious as their financial position is strong and wouldn’t preclude them from starting earlier.  I guarantee they had a protocol for the Phase 2 study planned probably two weeks after the Phase 1 study started.

I think Alnylam is going to hit the same problems that scuttled Isis’ drug discovery programs.  For me this is an obvious short.  The trouble is, the stock is inflated based on hype surrounding RNAi.  Once the market realizes it’s just hype, the stock will crash.  In situations like this I think the technical analysis will show the way, and I will be waiting to see when ALNY’s technicals (which are looking sharply up right now) start to deteriorate strongly.

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.