Big Pharma: Capitalism or Extortion?

Biotech company Alexion is paying $8.4 Billion to acquire Synageva, nearly double the target's market cap. While the terms of the acquisition are fascinating, the proposition evokes a philosophical quandary: Why would a company pay such a large premium to acquire a firm with one drug that treats a genetic disease affecting 3,000 people? The answer: Business.

Synageva's product hasn't hit the market yet, but is in late stage development. The process of getting a drug to late stage development is incredibly difficult, hence the premium. Still, how can Alexion expect to make their money back if the drug can only help 3,000 people? The answer: Business.

Since this drug is the only treatment available, insurance companies are forced to pay for the drugs, regardless of price. This is fantastic for the 3,000 people affected with the disease. A company found an opportunity to fill a market need and capitalized on it. Joseph Schwartz of Leernik Partners estimates Synageva could charge about $350K per patient annually for the drug. Society flips the bill, as insurance costs skyrocket. 

However, on the flip side, society benefits greatly. Pharmaceutical companies need large incentives to pour money into the R&D necessary to create life saving drugs. Without these incentives there would be no drugs and no innovation. Regulators exacerbate the process further by offering incentive to companies like expanded periods of market exclusivity.

Still, at a certain point, one would expect some type of balance between big pharma companies stronghold on insurance companies. Structurally, an equitable answer is unlikely to come to fruition any time soon. Biotech is one of the few industries experiencing rapid and meaningful innovation. It should come as no surprise that valuations continue to be stretched in the $IBB. Biotech offers investors safety from forex fluctuations while adding exposure to innovation and consolidation.

The 124% premium wets the appetite's of investors further. The trend of market consolidation mixed with cheap financing and rapid innovation reminds investors of how profitable small cap buyouts can be. While valuations may be stretched and the pharmaceutical industry as a whole can be extremely speculative, opportunities are still abundant. Biotech is experiencing growth, something lacking across the board.

November Job's Report

Extremely strong top line from November's job report: 321,000 with upward revisions to previous reports. Although this is a fantastic sign, two things stuck out to me: Civilian Labor Force Participation Rate & Wage Growth. 

The Labor Force Participation Rate was unchanged and has been essentially unchanged since April. This is very troubling. Why are more people not participating in the labor markets? Are we lacking in quality jobs? The number is around the 36 year low. Troubling to say the least. 

http://data.bls.gov/timeseries/LNS11300000

• Europe is facing deflationary pressures, and the ECB may not be able to be proactive enough to do anything about it. 

• We have seen some slowing of growth in Asia. 

• The weakening of the  Yen may cause Japanese pension funds to bring money into the US. 

• Increased Geopolitical risks will cause instability across Europe as well as the Middle East. 

• Economists believe Saudi Arabia and UAE can break even around $70 Crude (See Bloomberg Article).

• Russia is low on foreign currency reserves and facing a deep recession.

• The US has experienced job growth, albeit its job quality is questionable. 

• In terms of Financial Markets, investors from around the globe will continue to invest in the US as it shows the most stability and opportunity for growth. 

• Never underestimate Political Instability.

Right now, look for exposure to large cap stocks. As a hedge, try to utilize this great tool via Ishares, Correlation Tracker. Personally, I have increased exposure into Utilities as a hedge and have considered buying put options in the SPY as a hedge. However, if there is a pullback, cash on hand may be a better alternative than engineering financial insurance. Looking at macroeconomic trends, a pull back could be a great opportunity to lower your cost basis. There most likely isn't a better country poised for a profitable future. Other Risks: 

• US multinationals are still pulling a large portion of their revenue and profit from Europe and around the World. 

• US companies with larger exposure to international markets will have more trouble meeting guidance. 

• Perhaps this is an opportunity, if and when it happens. 

• The strengthening dollar could limit US exports. 

• The US is a consumer based economy. If there was a choice between substantial increases in consumer spending and strengthening of the dollar, I'll take consumer spending. 

• The polar vortex could limit winter sales. 

• Disappointing spending levels from black "Wednesday-Friday."

In terms of wage growth, things are  not looking much better. Over the year, average hourly earnings have risen by 2.1 percent. This might sounds pretty good, but lets compare to inflation. The CPI is up 1.7% year over year through October (CPI Index). 40 basis points is nothing to celebrate, in my opinion. 

Yes, jobs are being created but Wall Street, the Federal Reserve, and especially elected officials need to realize that Fiscal Policy is the obvious step. QE has provided once-and-a-lifetime financial returns. There is no doubt that the Financial Markets are where they are today due to the actions of the FED. The FED stepped up when Washington stepped aside. Without the FED, the employment situation would be incredibly worse than it already is. The FED has done more than enough. Politicians cry foul at the FED but have not stepped up to provide any long term solutions. In fact, instead of drafting something productive, they are spending their time trying to make the FED's decision process more public and increase their reporting visibility in front of Congress from its Semi Annual mandate (WSJ Article). The last thing we need is for Politicians to increase their impact on our central bank, which by law, needs to be independent. 

It is well known that the US is in a high yield bubble. As investors chase yield, standards have been limited to say the least. Still, the greater question is, does anyone actually care? 

The US is poised to continue to experience economic growth that will outpace that of other countries.

On a final note, the media has blown up the impact that US consumer will face with the fall of oil. Many US consumers have already locked in the price of heating oil, although this drop could be more important than gasoline prices.  (Oil Prices). The average US consumer spends ~ 4% on gasoline compared to spending ~ 13% on food. In case you have been looking for inflation, it is already seen in food prices. Food has risen 3.1%, outpacing inflation. This is a serious problem and the street is blowing gas prices out of proportion. 

Economic Events

Next Week we have some very interesting earnings and economic data.

Economic Announcements

Monday: Pending Home Sales

Tuesday: FOMC Meeting Begins, Case-Shiller HPI, Consumer Confidence, Durable Goods Orders.

Wednesday: FOMC Meeting Announcement.

Thursday: GDP and Jobless Claims.

Friday: Consumer Sentiment.

Incredible Week

What an incredible week in financial markets. I think the Movement in the VIX (measure of volatility) puts everything in perspective. On January 2, 2014 the VIX hit a high at 14.59 in the trading day. On Wednesday October 15, 2014 the VIX hit a high of 31.06. To put things mildly, volatility has picked up. But, volatility Is just that, volatility. This pullback has brought down valuations and increased yields on many stocks. The fundamentals are in the market. Although the buy on the dip mentality was a great strategy for the first 9 months of 2014, it might not be the best for the end of the year. We are seeing massive 300 point rallies in the Dow daily. Of course it is difficult to time the market, but be extremely careful when entering. I would advise buying in multiple orders over the course of a couple weeks in order to get a more realistic cost basis.

In terms of fundamentals, we are seeing somewhat of a reversal in the difference between the real and the financial economy. The table below summarizes:

This week gave some really interesting and mixed earnings. A few notes on the table. Netflix did lower guidance and got guillotined for it. Google did take a hit as well. Bank of America would like to say they have put the past behind them and Goldman absolutely destroyed earnings but did have several accounting revisions to go alone with negative quarter over quarter investment banking growth. But, the real economy revealed to me the strength of the US economy. When companies like Honeywell, GE and United Rentals are making money, the market has to react positively. An interesting Earnings release to me was Dominos who beat earnings. I have them in the real economy because food is a necessity yet it could still be considered discretionary so take with that what you will. The mix of financial earnings sheds light on the industry. Regulation has fundamentally changed the face for many of these banks. In the meantime as people continue to refinance like crazy, I am bullish on SunTrust, WellsFargo, and PNC.

The Fed is still a topic of major concern. Instead of talking about the stimulus discussion I would like to point out Yellen’s comments on economic inequality in the United States. This story came out on Friday so the market hasn’t had too much time to react. But, I believe that this is a fantastic sign from the FED. It is clear that Ms. Yellen understands the difference between the real and the financial economy. While the financial economy has recovered, it is clear the real economy hasn’t and Ms. Yellen believes the same. Highlights from her comments include the following:

• The past several decades have seen the most sustained rise in inequality since the 19th century after more than 40 years of narrowing inequality following the Great Depression," she said. "By some estimates, income and wealth inequality are near their highest levels in the past hundred years, much higher than the average during that time span and probably higher than for much of American history before then."

• The wealthiest 5 percent still hold two-thirds of all assets, and that while there have been significant gains at the top of the spectrum, things have been stagnant for the majority."I think it is appropriate to ask whether this trend is compatible with values rooted in our nation's history, among them the high value Americans have traditionally placed on equality of opportunity." The Fed chief said that wide wealth disparities can make it harder for the poor to move up the income ladder, and also warned of the burden of student loan debt, which quadrupled between 2004 and 2014.

• On Friday, Yellen said "some degree of inequality" is natural and indeed "arguably contributes to economic growth, because it creates incentives to work hard, get an education, save, invest, and undertake risk.” However, that same inequality can limit access to economic resources for those lower on the ladder, "thereby perpetuating a trend of increasing inequality."

Fundamentally, regardless of political ideology, if you are not at a bare minimum paying attention to inequality in the US, you are out of your mind. Yellen’s realistic and frank view on such a pressing issue is extremely refreshing to me. If the FED really wants to make a splash, it should begin to buy student loan portfolios instead of the mortage-backed securities in QE1 and QE3. Relieving students of even a fraction of student debt will immediately stimulate growth because young people want to spend money. Young people want to buy houses and cars, to have kids, buy clothes, and do the things most people liked to do when they were young professionals. Now that we have an entire generation crippled by student loan debt, who is going to buy the next round of houses and stimulate the economy? Follow “this link” for her entire speech as well as very interesting statistics.

On a side note, follow “this link” for a great article about a leveraged ETF betting against treasuries. Most people will read this and hope they didn’t have exposure. But, is now finally the time to buy?

Earnings Announcements

Monday: Apple, Chipotle, IBM, Rent-A-Center, Texas Instruments, and Halliburton.

Tuesday: Coca Cola, Ethan Allen, Harley Davidson, Interactive Brokers, Kimberly-Clark, Lockheed 
Martin, McDonalds, Mercantile Bank, Sonic Corporation, Verizon Communications, and Yahoo.

Wednesday: Abbott Labs, Allegiant Travel, Cheese Cake, Citrix Systems, DOW Chemicals, Evercore Partners, Ingersoll-Rand, and Xerox.

Thursday: 3M, Alliance Bernstein, Amazon, American Airline, Cabela’s, Catepillar, Dunkin Brands, Dr Pepper Snapple, Jet Blue, Nucor, and United Continental.

Friday: Abbvie, Colgate-Palmolive, P&G, State Street, United Parcel Service, and Wyndham Worldwide. 

Friday Funday

Very turbulent week in the Financial Markets. In an effort ton condense events and highlight strengths and weaknesses please see below. This post will be followed by a more in depth analysis of the Geopolitical risks touched on in "Negative Signs." The investment thesis of three weeks ago, increasing international exposure has backfired on many investors (this author included). Investors had projected much stronger outlook, but were potentially overly positive based on the appreciation of the dollar. Still, there could be hope for European travel as the dollar appreciates, European vacations will become much less expensive for US travelers. Still, this is a lofty projection. The US is still probably the best place to be overweight in both the long and short term due to a continued environment of Low-Interest rates, corporate earnings, and stability.

Positive Signs: 

• At face value, positive signs in the labor market – below a twenty year average. However, Wage growth and labor participation rates are troubling.
• Recovery in the housing market always a strong sign (within reason).
• Corporate earnings are growing – Q3 earnings expected to grow 5.5% due to currency volatility. 12 month projections at 8.5% (Wells Fargo Equity Strategy). Real measure will be top line growth.
• Increased volatility will help traders and create opportunities for long term investors.
• Correction is a great time to lower cost basis and enter the market on the dip. The pullback also proves that there is at least a shred of rationality in the market.
• US Equity markets may still be the only game in town.
• Drop in oil prices will hurt energy stocks, but will benefit discretionary spending just in time for the holiday season many retailers depend on. Crude prices have dipped to July 2012 lows.
• A global slowdown will continue to encourage investments in the US. The money that flew out into international funds, attempting to take advantage of a stronger dollar could potentially flow back into US equities. • Companies are focused on adding shareholder value.
• Stronger than expected Alcoa Earnings.

Negative Signs: 

• Macro Weakness – Global slowdown stretching beyond Europe, additionally China is worrying many investors. IMF has significantly cut its projections.
 • European slowdown is a larger threat than originally expected. Germany has only fueled the fire and has not been able to offset negative data from Europe.
• Inflation is not hitting targets.
• Negative currency headwinds for US Corporate earnings have been extremely difficult to hedge.
• 95% of Profits in the S&P have gone to Buybacks and Dividends. Buybacks should be conducted when equities are seen as undervalued, very difficult to make that case for the majority of S&P companies. When money returned to stockholders exceeds profits, companies are dipping into their piles of cash instead of investing in real assets that will actually stimulate the economy.
 o Bloomberg: The S&P 500 Buyback Index is up 7.5% this year through October 3, compared with the 6.5% advance in the S&P 500, after beating it by an average 9.5 percentage points each year since 2009.
• Continued proof the FED continues to propel the market. On Wednesday, the Dow jumped nearly 300 points when FOMC minutes revealed the FED was concerned by the global slowdown. Investors saw the fed as more “Dovish” than “Hawkish.” The underlying concern of the FED, a global slowdown is the same news that pummeled the market on Tuesday, proof investors are more concerned about FED policy than Macro risks.
• Geopolitical Risks: Ukraine-Russia, Potential exit by EU members, trend of secession in EU after Scotland’s independence bid (Northern Italy, Catalonia), ISIS, Turkish instability, Iran continues to be Iran, Assad continues to be in power, and Palestine still has not received an equitable solution.
• Health Risks: Ebola. How will this affect the markets? Airlines could be hurt. Next Week’s

Economic Calendar:

• Trading closed on Columbus Day
• Wednesday: Retail Sales and Atlanta Fed Business Inflation Expectation.
• Thursday: Philadelphia Fed Survey and Industrial Production.
• Friday: Housing Starts and Consumer Sentiment.

Next Week’s Earnings Calendar: 

• Tuesday: J&J, Citigroup, and Wells Fargo. 
• Wednesday: Bank of America, PNC, and BlackRock.
• Thursday (Huge Day): Blackstone, American Express, Philip Morris, UnitedHealth Group,         Goldman Sachs, First Citizens Banc, United Rentals, BB&T, EBAY, NetFlix, and Marriot Vacations Worldwide.
• Friday: Google, Morgan Stanley, GE Bank of NY Mellon, Independent Bank Corp, SunTrust Banks, and Capital One Financial.

As the big banks announce earnings, the XLF will be the ETF to watch. Bank earnings should hopefully provide some guidance on the strength of the real economy. However, potentially more telling will be AMEX, Philip Morris, and UnitedHealth Group. Additionally, Marriot Vacations is always very interesting to watch.

On an ending note, Leon Panetta has hit the airwaves this week. Panetta feels that the political polarization in the US is a bigger threat to National Security than many terror organizations. I couldn't agree more with Panetta on this one. Very, very insightful man who I would highly recommend listening to. Looking forward to reading his book over winter break. 

Strong Numbers, weaker support

The S&P fell 1.599% from Monday's close of 1977.80 to 1946.17 as talks of the long awaited "pull back" continued. To many investors, this "mini correction" was welcomed. Whenever there is a price adjustment in the market, it implies that investors are at least somewhat rational and reminds investors of the issues the market faces: economic growth, geopolitical factors, and corporate earnings. Additionally, from a trading perspective, volatility has picked up. The VIX hit an almost 2 month high at 16.71 on Wednesday before normalizing back to 14.55 on Friday's positive job numbers.

As we all know, the greater the volatility, the greater the risk, and the greater the rewards. The view on the street is that volatility will continue to pick up as we move into Q4 and traders closely eye earnings as well as significant Fed “speak” including FOMC minutes next week.

The Fed is in a really interesting spot now that the unemployment rate has moved down to 5.9%. The 248,000 increase in non-farm payroll employment numbers is fundamentally a good thing. Unemployment is at its lowest level since July 2008. However, no numbers can come through the wire without receiving some criticism. Friday's numbers were highly affected by an upward revision from July and August numbers, which the market had already expected would be revised. New job creation numbers of 142,000 did unfortunately miss the 200,000 mark the street was looking for. But, the biggest thorn in the side in this report is wage growth.

Increases in earnings only hit 2%, annually. This is negative as consumer spending is unlikely to increase without a significant jump in earnings growth. This speaks to the new era of corporate America. Corporations have been able to do more (increase Bottom Line earnings) with less employees for the past 3 years. Now that that they have hired some workers, they do not feel the need to increase wages as they understand supply and demand is still in their favor.

Although the unemployment rate might be 5.9%, that is not how it feels in the real economy. Employees still understand that mobility in the labor market is not what it once was and are hesitant to leave. The foundation for the 5.9% unemployment remains troubling as underemployment and labor force participation continues to plague the economy. But, the continuation of unequal wealth distribution is more troubling than anemic growth in income. The US has been playing the same story for the past 4 years, the rich get richer and the 99% get, something less than that. These other factors will weigh in on the Fed's decisions regarding short term changes in interest rates. The 5.9% unemployment can be deceiving to the naked eye, but did not start the market from executing a demand for buy orders. The buy on the dip mentality has continued to support the market the past two weeks of trading.

Until the US can realize that Education is an essential long term investment, public health is a right, and political polarization continue, economic growth will never hit its potential as our competitive advantage weakens. Alan Krueger brought up an interesting point on Bloomberg: proposing that now is an ideal time to implement an increase in the minimum wage. While I agree that an increase in minimum wage could benefit the economy, I think giving businesses incentives to spend in the US by buying real assets such as property, plant, and equipment, would have a more sustainable impact on the economy.

Dragenomics

Now that we are in a post Alibaba IPO world, with 3 consecutive quarters of Equity performance, and a falling Euro relative to the dollar, it is time for every investor to take a step back and evaluate their positions. As we enter October, the historic month mutual funds sell their positions to cash out; it is clear the correction that has been predicted for the past year and a half has not occurred. The past two years have been a bad time to avoid equities. The buying on the dip mentality has worked, and although we have seen dips there has not been a correction. A strong defensive portfolio, with significant equity exposure, is the only way to continue to generate above average returns. Interest rates cannot fall much lower, and when the rise comes, bond managers will continue to be hit with redemptions. The bond king himself, Bill Gross, shocked investors on Friday by leaving PIMCO, the company he started. His work in bond futures was flat out inspiring. See “Gross Used $45 Billion in Derivatives ” for more. But, Gross’s departure is not a fundamental threat to the financial markets.

As expected, BABA surged on its first day and raised over $25 Billion. Kudos to the bankers for leaving the valuation in line with those of other Chinese internet companies. The bankers were able to issue additional shares and raise an extra $2 Billion than expected, courtesy to the Green Shoe option. Although the growth rates at BABA are ripe, the corporate governance structure leaves a lot to be desired in my eyes. The most interesting aspect of the BABA IPO was actually indirectly related to BABA. Investors had been worried that institutional investors would have to liquidate tech positions in order to buy BABA. Investors were correct that the markets did experience a sharp downturn. However, the losses did not spiral out of control and have recovered from Thursday’s Lows. The NASDAQ, S&P, and Yahoo (Major BABA Shareholder) inched down 1.48%, 1.37%, and .66%, since the September 19^th adjusted close, when BABA went public. BABA is due to posts earnings in November, it will be very interesting to see how the market reacts. I would argue that poor BABA earnings could increase sentiment as we begin to close out the year. Even with a poor fourth quarter, Investors have a lot to be happy about.

Year to date as of Market Close 9/26/2014 the S&P, NASDAQ Composite, and DJIA are up 7.3%, 8.00%, and 3.02%[1]. These numbers are welcomed given an ambivalent federal reserve and relatively stable, yet potentially stretched valuations. The S&P, NASDAQ, and DJIA have P/E’s (TTM) of 19, 24, and 16.[2] While these valuations are nothing to salivate over, equities are still the only game in town. So, in some respects valuations are justified. Additionally, as the 10YR T-Bill is 2.54%, investors need to get yield somewhere. Going into next week, the number to look for is undoubtedly job numbers on Friday October 3^rd. These numbers could dictate how the market will react in October, as Mutual Funds begin to sell positions and analysts begin to size up the holiday season. So, the question everyone is think: Where is the hedge right now?

In my opinion, the best way to trade in this market is sticking to Index ETFs. Buying puts on these positions are and extremely cheap way to insure your portfolio. To lower the cost of the puts, sell some stretched calls. Yes, you will be limiting your upside but I do not see many macroeconomic events that could radically push returns further. Looking towards 2015, it is time to evaluate the Euro – Dollar relationship. After Draghi’s announcements on interest rates[3] the Euro has been falling quickly against the dollar. The Euro is at its lowest price relative to the Dollar since March of 2013. This movement gives investors a few potential ways to profit. Obviously the pure currency trade is an option. But, for long term value investors, I believe there are better way to profit over the course of the next year. As the ECB begins to pump billions into the Euro Zone, there is potential that this quasi “quantitative easing” will give European financial markets the boost they have been craving. But, just like in the US, the ECB has had trouble hitting their inflation targets. This could mean a prolonged easy money period for Europe. Draghi actually announced that target interest rates on deposits will fall from -.1% to -.2%. This means that the velocity of money could be faster in Europe than the US as banks will prefer to lend their excess reserves rather than pay to house them with the ECB.

Still, there is a large question mark regarding when the European economy will take place. So, the dividend paying, European stocks look attractive. The IDV (Disclosure, this author has a position in the IDV) with a yield of 4.88% (9/27/2014) seems to be a way to find yield with international exposure.  The MSCI EAFE could also be a strong option. European stock with high yield could be tempting for European Managers to buy as they will eventually need to find yield and growth. If this does happen, large cap dividend paying stocks will most likely benefit. Lastly, US companies still have operations in Europe. Those companies with the largest sales volume in Europe might rally the most. It is important to remember we are in a globalized world. US companies with large European operations could offer the exposure needed to profit from easy money in Europe without as much of the risk. 

---

[1] http://online.wsj.com/mdc/public/page/2_3022-usclosingstk.html?mod=topnav_2_3021

[2] http://online.wsj.com/mdc/public/page/2_3021-peyield.html

[3] http://www.bloomberg.com/news/2014-09-04/ecb-unexpectedly-cuts-interest-rates-as-outlook-darkens.html