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Crystal Balls and Ground Glass


All you really need to know about the markets can be found in Psychology 101 (know thyself), Sociology 101 (know the mob), and Econ 101.


He who lives by the crystal ball soon learns to eat ground glass...
– Edgar R. Fiedler, economist

I've learned the hard way the best way to lose credibility is to make grand forecasts in January about events to arrive over the next 12 months. Like something out of a Warner Brothers cartoon, those of us who write about the markets can't resist even though we know the outcome is almost always the same – sort of like every time Wile E. Coyote straps on those rocket-powered roller skates to catch the Roadrunner.

I managed to avoid writing a prediction piece for the 'Ville last year, so the primary device I usually have for these articles – reviewing what I said and whether I happened to be right – isn't available to me. (Incidentally, I always look askance at anyone who writes a year-end prognostic column without a companion "See how bad (good) I did last year" piece. Maybe I'm odd that way, but I like to see if who I'm reading is simply a stopped watch or whether by luck or talent actually got something right a year ago.

The closest I came to a prognostic piece was something I wrote at the beginning of December last year. I gave it the unfortunate title of "Fascination Station" when it should have been something like "Throw everything you thought you knew out of the window." I still like this piece and, if you didn't read it then, I encourage you to read it now. If anything, it's more applicable today that it was 13 months ago.

Focusing on the Issues

In the most recent edition of Barron's, Alan Abelson wrote about how the bulls were lucky to have been right in 2006 and how their gains (particularly late in the year) were driven by the creation of large numbers of ETFs. If you know that ETF shares are only created when someone buys them, that statement rings a little desperate. My intent is not to string up Alan. Heck, I've used sketchier rationalizations in my time when things didn't go my way. His stretch just seems indicative as to how bad it has been for the bears in 2006.

When I guest lecture to college students about the market, I tell them all they really need to know about the markets can be found in Psychology 101 (know thyself), Sociology 101 (know the mob), and Econ 101. Economics 101 gives us the simple law of supply and demand, the king of all rules in the marketplace.

If you have a great deal of demand (money) chasing too few goods, prices will rise. If you have too many goods and/or not enough demand, prices will fall.

In 2000, the market was overrun by supply. Every Tom, Dick, Clarence, Jane, Hortense, and Ahmed was taking their dot-com IPO. Heck, some of the biggest IPOs in that time were companies that were created only to take other companies' IPO.

Huge supply begat cratering prices. Economics 101.

We had nice double-digit rallies in the major market indices in 2006. Care to take a guess as to how those gains translated into the total market cap value of U.S. equities? If trying to compute numbers or percentages is too taxing for a brain still adjusting to the fact another year just swept by (where does the time go?!?), pick a direction: Given the market was up double-digit percentages in 2006, did the overall market cap go up or down?

The answer, according to this article and the good folks from TrimTabs, is the total market cap shrunk by $600 billion in 2006. Even conservatively assuming the same amount of money is in the economy now as at the beginning of last year, fewer goods to buy with equivalent demand (money) means prices will go up.

Economics 101.

Crystal Ball

Absent exogenous shocks, therefore, a person trying to predict 2007 returns would probably be on the right track if they tried to predict where the supply of stock was going to go in 2007.

Raise your hand if you think the IPO market will come back and be hot, hot, hot. Yeah, my hands are still on my keyboard, too. I think IPOs will do better in 2007, but I don't believe we are embarking on the kind of traffic in new shares we saw in 1999 and 2000.

How about issuing shares for financings? Biotech posted another record year of raising capital in 2006. That's not surprising since the costs of drug development are soaring and there are a ton of biotech companies out there. In "normal space" (not biotech), companies are turning to the debt markets for needed funding. With the SEC finally cluing into how hedge funds were printing money via inside information on PIPE deals, I expect that steady source of new share supply to dampen more in 2007.

Insiders selling? Oh, it will increase in 2007 accompanied by much handwringing. Look at the float for most companies though and you'll see the effect of this is more psychological than real on a macro basis.

That pretty much takes care of the inflow side of the supply ledger. What about the outflow?

Raise your hand if you think buyouts will accelerate in 2007. I'd have both my hands in the air except that makes it difficult to type. In the rest of the market, LBOs look increasingly attractive to management teams tired of the anti-competitive nonsense that is SarbOx. In my corner of the world, biotech companies will be like Cabbage Patch Dolls in the 1980s – flying off the shelves in a consumptive frenzy that will make heads spin. Big pharma and biopharma is in big trouble. The new Congress is going to aim right at the heart of their wallets – mass-market lifestyle drugs sold at high margin via big advertising campaigns and a reliance on lack of price negotiation power by consumers.

The Democrats are not serious about passing significant healthcare reform legislation in 2007 (aside from moderate new post-approval safety monitoring regulations in the renewal of the PDUFA legislation). They merely want to introduce these issues as points to bludgeon the GOP with what will be the second longest presidential election cycle ever. The GOP will play along, voting against the more far-reaching proposals and provide prime talking points for Democrat party favorites (particularly Sen. Clinton) on the Presidential campaign trail.

Just in case the Democrats get the White House in 2008, though, big pharma and biopharma have to act now. Not only must they acquire companies to replace lost revenue due to patent expirations, they also have to completely reposition their business towards specialty lines of care. What do I mean by "specialty?" Drugs and treatments you won't get from your family doctor (primary care physician or PCP in today's lexicon) – things prescribed by specialists like oncologists, cardiologists, OBGYNs, urologists, dermatologists, rheumatologists, neurologists, endocrinologists, etc.

Specialists treat more serious ailments that generally have much better defined risks. Better defined risks allow for easier risk/reward decisions by regulators when balancing a drug's benefits versus its side effects. Among these specialized areas, expect oncology drugs to be particularly attractive as no lawmaker wants to be branded as preventing dying cancer patients from obtaining life-saving medications.

The world economy is not on any footing traditionally thought of as stable. If you think about it, though, when was the last time you ever heard a macroeconomic bear utter the words, "I think the world financial system looks to be in pretty good shape right now." Absent some exogenous event (aliens landing, World War III, more dumb rules like SarbOx, etc.), I don't see 2007 as the year the sun burns out. Since the existing macroeconomic problems could rapidly accelerate or magnify any significant decline (regardless of cause), you have to factor them into your risk analysis. But shorting the market based upon a Chicken Little economic collapse happening anytime soon means you'll probably go broke before you are "right."

To sum up, I see the path of least resistance to be up for the market. I am particularly bullish on the biotech sector, especially if Dendreon (DNDN) sees a positive panel (1Q 2007) and FDA approval (May 2007) of their drug Provenge (for details on why this one company matters, see this).

Join me in this space one year from now and let's see whether I'm eating ground glass or not.
Position in DNDN

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