It’s not often that the Federal Reserve Chairman calls out an industry as overvalued. Janet Yellen hasn’t just done this once with the biotech industry, but twice in the past year. Yellen might not be an industry expert, but you would assume that she has some wise and connected people helping her with this assessment. Perhaps she’s right and perhaps she’s wrong, but let’s take a look at why she decided to send this warning to investors. (For more, see: Does a Safe Biotechnology Stock Exist?)
There have been many correlations between the dotcom bubble of the late 1990s and today’s biotech run. On July 2, 2010, the Nasdaq Biotechnology Index traded at $790.90. On June 30, 2015, it trades at $3,864.68. Over the past year, there have been five corrections north of 6.6% for the index, but in every instance, the index recovered within one month. This has made it difficult for technical analysis investors to figure out what’s going on. The answer is usually found in fundamental analysis anyway.
The Nasdaq Biotechnology Index has soared in recent years for several reasons. One, low interest rates and easy credit have helped fuel the rally. Two, speculators will invest in the riskiest equities in bull markets, knowing they have the most to gain. Three, there has been some earnings growth, but not across the board. Four, the Affordable Care Act — Obamacare — has helped fuel biotech firms. Five, Big Pharma has called for new products, which some biotech companies have been able to deliver. Six, the FDA has implemented new policies to accelerate the approval of breakthrough drugs. Seven, a good spur of quality M&A activity. The latter has played a big role; according to PwC, in the first quarter of 2015, there were 35 deals completed in the pharmaceuticals and life sciences industry, representing deal value of $166.3 billion, a value higher than 2014 total deals alone. (For more, see: Top Healthcare Stocks Fueled by Obamacare.)
Now let’s take a look at the bearish side of the argument. What stands out right away is that the Nasdaq Biotechnology Index is trading at 53 times earnings, according to Bloomberg. By comparison, the S&P 500 is trading at 20 times earnings. An argument can also be made that many biotech companies lack revenue growth to justify their gains. Without that revenue, many early-stage companies are more akin to technology companies than biotechnology companies. Additionally, there has recently been an increase in failed clinical trials. But the biggest threat is the potential for reduced access to easy money for biotech firms. If this environment becomes a reality, then rallies in speculative-heavy industries will come to an end.
Below are bull and bear exchange-traded funds (ETFs) that track biotech stocks (all numbers are as of July 1, 2015).
iShares Trust - iShares Nasdaq Biotechnology ETF (IBB)
Purpose: Tracks the investment results of an index composed of biotechnology and pharmaceutical equities listed on the Nasdaq. Its largest holdings are large-cap stocks, which provide more safety than investing in individual biotech stocks (relatively speaking).
Total Assets: $9.04 billion
Average Daily Trading Volume: 1.5 million
Dividend Yield: 0.12%
1-Year Performance: 43.60%
3-Month Performance: 7.45%
ProShares Ultra Nasdaq Biotechnology (BIB)
Purpose: Tracks two times the daily performance of the Nasdaq Biotechnology Index.
Total Assets: $902.61 million
Average Daily Trading Volume: 681,524
Dividend Yield: N/A
1-Year Performance: 94.79%
3-Month Performance: 14.11%
ProShares UltraShort Nasdaq Biotech (BIS)
Purpose: Tracks two times the inverse daily performance of the Nasdaq Biotechnology Index.
Total Assets: $125.84 million
Average Daily Trading Volume: 208,970
Dividend Yield: N/A
1-Year Performance: -59.66%
3-Month Performance: -16.75%
Direxion Daily S&P Biotech Bear 3X ETF (LABD)
Purpose: Tracks three times the inverse of the performance of the S&P Biotechnology Select Industry Index.
Total Assets: $7.86 million
Average Daily Trading Volume: 45,108
Dividend Yield: N/A
1-Year, 3-Month Performance: N/A
1-Month Performance: -18.21%
Is the biotech rally over? Not yet, but the end is quickly approaching. Like with most other strong industry rallies, the move to the down side will shake out the weak hands prior to biotech rising again in the future. There will be more resiliency in large-cap stocks, where you will almost always find actual revenues. (For more, see: Pharma vs. Biotech Investing: Worth the Risk?)
Dan Moskowitz does not own shares in IBB, BIB, BIS or LABD, but he might initiate a position on the short side in the near future.