PMC Weekly Review - September 25, 2015

A Macro View – Biotech: Is the Bubble About to Burst?

Looking back over the recent bull market, it is hard to ignore the high-flying Biotechnology industry. In fact, the NASDAQ Biotechnology Index is up more than 400% since it began its rally in early 2009, and is on pace to outperform the broader equity market for a fifth consecutive year. The industry that uses biologic systems to develop products with the goal of ultimately improving lives and health has indeed benefited from many successful innovations over the past few years. Biotech’s global market capitalization has surged to over $1 trillion, driven by record breaking IPO issuance, merger and acquisition activity, and new drug approvals. This growth means it is an increasingly significant component of indices and portfolios, and according to Barron’s, Biotech’s weight has reached an all-time high in most benchmarks. This upward momentum has sparked discussions amongst investors over the past few months about a potential bubble burst similar to Information Technology in the early 2000’s. Recent market volatility demonstrates how susceptible the industry is to large price fluctuations. Others suggest that the sector remains fundamentally strong despite all the noise, and attractive opportunities still exist. One thing is certain: Biotech’s importance should not be overlooked, given its increased allocation in equity indices, and investors should scrutinize carefully their holdings in this space.

Those who believe Biotech is poised for significant declines emphasize how pricey the sector has become, especially since many of these companies are currently unprofitable. Data from The Wall Street Journal shows more than half of Biotech companies in the NASDAQ Biotechnology Index are losing money, and many investors consider these stock prices to be inflated and their momentum unsustainable. The iShares NASDAQ Biotechnology ETF (NASDAQ: IBB) lists a P/E ratio of over 28x, which is not excessively expensive for a growth sector. However, this P/E figure excludes companies that do not earn a profit; if the multiple were adjusted to include these stocks, it would skyrocket to over 130x, which certainly is pricey. Based on this metric, relative valuations appear to be stretched, which could take a toll on merger and acquisition activity moving forward. On Tuesday, Severin Schwan, CEO of the giant Swiss drug maker Roche, stated “this whole segment is overvalued”, attractive purchase opportunities are “far, far away” from fundamental value, and expressed concern about the potential for a “collapse”. The diminishing M&A tailwinds, coupled with overvalued P/E multiples, have set the scene for a challenging environment, and one that potentially could burst the Biotech bubble.

Despite the pullback over the past several weeks, bulls are optimistic there is still room for growth in Biotech, and the volatility will not trigger a widespread crash in the industry. Although some compare the Biotech run-up to that of past market bubbles, others highlight this rally as being nowhere near as extreme as were Information Technology in the late 1990’s or Homebuilders in the early 2000’s. Illustrated by USA Today, the Biotech rally reached 400% in July, but at their peaks, IT and Homebuilders increased more than 1100% and 800%, respectively, before their subsequent, violent selloffs. From a technical perspective, Biotech is the number one relative strength industry (in relation to the S&P 500). According to the widely followed technical analyst Thomas Dorsey, of Dorsey Wright & Associates, “Everything still suggests the Biotech sector still has the strength, not just in itself, but on a relative basis.” Although the recent decline in Biotech was slightly more severe than the broader market, it followed a similar trajectory. Furthermore, in 2015 the S&P 500 Biotech (NYSE: XBI) is still outpacing the S&P 500 by a wide margin, as of market close Thursday: up nearly 17% versus down over 6% in the S&P 500.

No clear conclusions can be drawn about the short-term fate of Biotech, but it is displaying characteristics of a fragile industry. The NASDAQ Biotechnology Index* plunged 4.5% Monday, and was down a total of over 8.5% for the week (as of Thursday’s close) amidst a relatively slow week of major economic news after presidential candidate Hilary Clinton tweeted her plan to outlaw certain pricing strategies prevalent in the industry. A good deal of speculation surfaced about whether this may be the beginning of the end for the Biotech rally, while others are calling it merely noise, as fundamentals appear solid. Given the looming uncertainty, investors need to recognize that as Biotech has become a more substantial part of the global equity landscape, it carries greater risks of a potential bubble burst.

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