On June 9th, we indicated our view that Biotech was due for a rally, following the greater than 23% slide the NYSE Arca Biotechnology Index ($BTK) suffered between late February and mid-April. We cited a favorable momentum backdrop for the Biotech industry as well as the broader Health Care sector, constructive seasonality and improving earnings estimate revisions as support for this premise.
Our outlook proved prescient, as $BTK is up 16.2% since we penned that pre-summer note. The S&P 500 Health Care Sector Index gained 7.3% and the broad U.S. stock market, as proxied by the S&P 500 Index, advanced 2.6% over this same horizon.
It now appears as though some of the supports we named as underpinning our constructive bias have reversed. Specifically (and primarily), our medium-term, price-based momentum gauge hinted almost a couple of weeks ago that an inflection was imminent. It now appears as though this measure is slated to record its high water mark for the current cycle this week.[tweet https://twitter.com/MrMosaicTheory/status/504394527105646592]
Price action looks to be corroborating the ominous momentum indication, as, per Investors Intelligence, eight names in the biotech space registered buying climaxes last week, including heavyweights GILD and CELG.
[From Investors Intelligence: Buying climaxes take place when a stock makes a 12-month high, but closes the week with a loss. They are a sign of distribution and indicate that stocks are moving from strong hands to weak ones. Sellers into buying climaxes are right about 80% of the time after 4-6 months time.]
Popular media has linked GILD’s recent volatility with reports that the company is close to cementing licensing deals with 80 emerging market nations that would provide assess to their blockbuster hepatitis C treatment for about one percent of the price charged in the U.S.. This news reportedly stoked concerns that GILD’s list price for this treatment is unjustifiable and that pricing broadly is likely to come under pressure.
For CELG, a recent article in Barron’s identifies ongoing U.S. and European challenges to patents for its anemia drug as a source of investor uncertainty.
From a more macro perspective, according to Equityclock.com, absolute price weakness is the norm for biotech in September, while underperformance versus the stock market and the Health Care sector is typical throughout the Fall months.
As of yet, biotech earnings estimates have not come under pressure, however, we are not convinced that such fundamental deterioration is a requisite for industry declines and/or underperformance over the medium-term. To wit, the worrisome sell-off earlier this year does not appear to have been linked to worsening earnings.
The following table shows implied trailing 12-month EPS for nine of the top ten holdings in the iShares NASDAQ Biotechnology Index ETF at the February price peak and at the April bottom–one stock in the $IBB top ten does not generate positive earnings and is therefore necessarily excluded from this review (the top 10 stocks in this basket capture roughly 60% of the cap-weighted index). While $IBB shed more than 20% of its value over this six week span, implied trailing 12-month earnings for most of these names actually grew–in some cases growth was quite hearty.
While, in a perfect world, we might prefer to compare expected to actual earnings to assess any linkage between the earnings outlook and price performance, even the limited information at our disposal hints that there is a precedent for price performance to deviate from the path of per share earnings growth.
Rather than a breakdown in fundamentals, an unwinding of the outperformance of biotech shares might simply coincide with a reversal of the momentum trade (recall that biotechs dropped a quick 6% in four days in mid-July after Fed Chairperson Yellen suggested that valuations were concerning for select pockets of equities markets such as small-caps, social media concerns and biotechs).
A reversal of the outperformance of the momentum trade would also fit with our view that a rotation away from cyclicals and into defensives in due.
In closing, absolute and relative momentum for biotechnology suggests the run off the April lows is about done. At the same time, price seems to be validating the ominous signals from momentum. Moreover, we are entering a seasonally weak period for the industry. Accordingly, I am inclined to book absolute and relative profits accrued since we turned bullish biotech on June 9th.