Biotech stocks have reached a critical juncture, with one of two major sector funds breaking out to an all-time high while its rival struggles at multi-year resistance. Who-leads-who in coming weeks may determine the group's fate well into the third quarter. A combined breakout would open the door to much higher prices, while a rally failure by the leading instrument would set the stage for much lower prices.

The sector has posted impressive returns so far in 2020, with huge speculation about winners and losers in the hunt for coronavirus vaccines and treatments. The pandemic has lifted other biotech stocks as well because rallies in broad-based funds are lifting prices all across the capitalization spectrum. The "event" has been particularly beneficial to small caps, with those companies more likely to overstate progress in hopes of attracting equity capital.

Realistically, the vast majority of coronavirus research will eventually go to waste because some treatments and vaccines will work better than others, eliminating the demand for further investigation. A time will also come when demand for these pharmaceutical compounds falls precipitously because the virus has run its course and winners have manufactured enough dosages to meet worldwide demand and future challenges.

Chart showing the share price performance of the SPDR S&P Biotech ETF (XBI)
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The SPDR S&P Biotech ETF (XBI) is constructed from an equal-weighted index, with small-cap, mid-cap, and blue-chip stocks treated equally when computing total exposure and pricing. The fund posted historic returns between 2010 and 2015 before topping out just above $90 and turning lower into the first quarter of 2016. Scandals at that time involving Valiant Pharmaceuticals, now Bausch Health Corp. (BHC), and Martin Shkreli's Turing Pharmaceuticals undermined investor confidence while drawing unwelcome government attention. 

The fund bottomed out at $44.16 in February 2016 and bounced in a persistent recovery wave that finally completed a round trip into the 2015 peak in January 2018. It broke out immediately, but trade war tensions undermined buying interest, adding just 10 points before topping out in June. A selloff into December ended in the mid-$60s, giving way to a 2019 uptick that failed well below the 2018 high at year end.

The fund fell more than 35 points into March 2020 and bounced, recovering ground at the same trajectory as the prior decline. It reached the February high in April and kept on going, breaking out above the 2018 high in May. Price action then eased into a symmetrical triangle pattern that is still in force one month later. This holding pattern makes perfect sense because its primary rival remains stuck under long-term resistance.

Chart showing the share price performance of the iShares Nasdaq Biotechnology Index Fund ETF (IBB)
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The iShares Nasdaq Biotechnology Index Fund ETF (IBB) is built upon a market-capitalization weighted index, with large and mid-sized biotech companies comprising a greater share of total exposure and pricing. The fund topped out at $134 in July 2015 following a multi-year uptrend and sold off to $80 in March 2016. The subsequent uptick gained ground into the third quarter of 2018, stalling more than 10 points below the prior high.

A selloff into January 2019 carved the third higher low since 2016, but the fund made little progress until the fourth quarter, when it rallied back to 2018 resistance. A decline starting at that level posted the fourth higher low in the series during the first quarter rout, setting the stage for a strong bounce that broke out above 2018 resistance in late April. It reached the 2015 high a week later and has spent the past four weeks grinding sideways at resistance.

An XBI decline through $100 will end this divergence with a failure that reinforces range resistance in both funds. Conversely, IBB needs to clear resistance at $136 on higher-than-average volume to confirm a sector-wide breakout that sets off strong buying signals. Both instruments could gain another 20% to 30% in a relatively short time frame if that happens while allowing them to continue their market leadership.

The Bottom Line

Biotech funds have been testing 2015 levels for a month but still haven’t confirmed breakouts that would signal much higher prices.

Disclosure: The author held no positions in aforementioned securities at the time of publication.