Navarro's Big Economic Picture
October Bull

We enter the historically best month for the stock markets looking at an increasingly bullish scenario. Yes, the economy is slowing, but business investment and activity appears to be holding strong.  Yes, there is inflation, but more and more voices are suggesting that the worst of the inflationary pressures are over.  Yes, there is a rapidly declining housing market, but with inflationary pressures moderating, interest rates on the long end are falling.  This could revive somewhat the refinancing market and thus help fuel consumption. Lower interest rates could also help the housing market find if not a bottom than a much softer landing.

The other major trend which continues to weigh heavily on my mind is the issue as to whether are not we are in the midst of a historically significant decoupling of the U.S. economy from the U.S. stock market. Historically, the stock and bond markets have both been reasonably reliable leading indicators of economic activity. To the extent, our manufacturing base has migrated abroad and U.S. corporations are becoming increasingly global entities, what may matter more is the state of global economic conditions. For example, even if the U.S. economy slows, if Asia and India and Latin America keep cranking, there’s plenty of earnings to be had for U.S. companies – and therefore a possibility that their stock price performance may not reflect U.S. economic conditions.

All of this said, while I enter October in a bullish frame of mind, I also am wary of a possible correction in the months ahead that may well be the major one we have thus far avoided.

This Week's Market Movers

There’s mucho data this week and therefore a lot of candidates for to top market movers. The ISM index on Monday and factory orders on Wednesday will give us a nice read on the supply side of the economy. Auto sales will be of interest on the demand side. But the big market mover is likely to be the monthly jobs report.  Lower than expected job creation will be perversely bullish as it will reinforce the declining inflation scenario and conversely. Place your bets.

Portfolio Shorts and Longs

My stock of the week is Star Scientific (STSI). According to Market Edge, “Develops and licenses technology for the curing of tobacco so as to substantially prevent formation of carcinogenic toxins present in tobacco and tobacco smoke, mainly tobacco-specific nitrosamines. It also makes very low-nitrosamine smokeless tobacco pro ducts and discount cigarette brands.” The technicals are strong.  Bon Chance. Two other penny picks – HTI and INSM – continue to base nice with risk/reward favoring the upside.

Vaino's Biotech Corner
East of Hollis-Eden? (or, Hollis Eden: Paradise Lost?)

A few weeks ago I wrote suggesting a straddle to take advantage of volatility in Hollis-Eden Pharmaceuticals (HEPH). HEPH was waiting to hear from the US Government (HHS) as to whether or not they’d get a contract on a drug to potentially combat acute radiation syndrome (ARS). HHS had said they would render a decision around September 15. Well, September 15 came and went with no announcement. To be clear, a look at intra-day charts the last two weeks of September shows substantial volatility. Closing the Oct 7.5 straddle at the right time on September 26 would have been a good move. Implied volatility for Nov 06 HEPH options is an impressive 93%!

On September 26 HHS announced they had asked HEPH to extend until November 30 its offer to provide HHS with their drug. Novelos Therapeutics (NVLT.OB), who is also competing for this procurement received the same notice. I still think this is a good volatility play, as the company either sinks or swims based on this procurement and a straddle with December options is a good play. Now that the stock price is closer to $5, I would go with $5 strikes.

For those looking to speculate, toward the end of November I think HEPH will be a great stock to short. My take is the same will happen November 30 as happened on September 15, that is, no announcement and the stock will take a huge plunge. Myself ,I also picked up some NVLT.OB----a purely speculative and highly illiquid play, but I think they have as good a shot at the HHS procurement as HEPH and the stock is less than a buck.

Let’s look more broadly at why trading biotech is fun – and risky.

Where has all the volatility gone, long time passing?

I’m going to compare for you the volatility of stock prices across some sectors as well as the broad market.  As a general observation, volatility seems to be on hiatus these past few months. The CBOE’s Volatility Index (VIX) provides a snapshot of expected stock market volatility over the next 30 days. With the VIX flirting with historic lows, I was wondering just where exciting places to trade might be.

Now, as mentioned above, the VIX represents the implied volatile (IV) in the stock market for the next month.  As a comparison, beta represents the historic volatility of a stock. To compare volatilities of different sectors of the market, I thought it would be useful to look at implied volatilities of options on ETFs representing different market sectors. To get implied volatility I looked at the closest in-the-money Nov 06 call using the options calculator from the CBOE. I left interest at 5% and ignored dividends: this introduces errors, but this isn’t quantum mechanics—I’m just interested in a relative ranking. Options are more thinly traded than stocks, so for price I used the halfway point between bid and ask. I tried to use the same ETFs I used two weeks ago in comparing correlation coefficients. A couple of the ETFs (IYC, UTH, and IYK) were too thinly traded to have a meaningful price.

Representing the market as a whole I used, the Standard  & Poor’s 500 ETF, SPY. Representing biotech and big Pharma, I used the ETFs BBH, IBB, and PPH. To compare with other sectors I looked at call prices for the following ETFs: XLE (Energy Select Sector SPDR), HHH (Internet HOLDRs), OIH (Oil Services HOLDRs), and RTH (Retail HOLDRs). Here’s what I got from my calculations:

Perhaps not surprisingly, IBB, consisting of smaller biotechs, is expected to be more volatile than either BBH or PPH. High IV values for OIH and XLE are consistent with unrest in the Mid-East (unexpected?) and increasingly turmoil in the oil markets. My point in all this? Even with the market as a whole being low on volatility, which some people like—I guess—trading biotech stocks can still be fun!

“Any trader or investor who ignores the power of macroeconomics over the world’s
financial markets will, sooner or later, lose more than they should—and if they are
trading on margin, perhaps more than they have.”
 -- If It's Raining in Brazil, Buy Starbucks

CONTACT INFORMATION
Peter Navarro
Irvine, California USA
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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.