Investors face an uphill task this year:Things have been difficult thus far but there will be selective opportunities to recover lost ground and perhaps record some gains this year.
The stock market has retreated sharply this year and quite relentlessly over the past few months. Biotechs have been in retreat since late last year and the industry group is well into a deep bear market with valuations on the S&P Biotechnology Select Industry Index (XBI) slashed by over 60% from their highs. Investors face an uphill task this year:Things have been difficult thus far but there will be selective opportunities to recover lost ground and perhaps record some gains this year.
A deep decline
Biotech valuations have fallen precipitously as the stock market encounters an environment not seen in nearly 50 years — spiraling inflation and an aggressive and determined Federal Reserve (FED). The S&P 500 (SPY) has declined 21% and likely has more to go based on a historical perspective.
The four major corrections or bear markets this century can provide some helpful insights, though the picture remains incomplete due to the uniqueness of the present environment. The 2020 pandemic-related pullback, and the brief recession, are omitted.
Biotechs declined sharply in each of these pullbacks. The 2002-03 period is not as instructive because the Nasdaq Biotechnology Index (IBB) was started right during the middle of the decline and the S&P biotech index did not exist.
Decline in the context of FED policy
What can be more useful is placing these pullbacks in the context of a FED interest rate policy reflecting the economic environment at the time.
During the first two periods the FED was working to prevent or manage a recession by cutting interest rates. The biotech indexes dropped less than the market did and for good reason. Biotechs are relatively less affected by slower economic growth than the broader market, and the declining interest rate provides support for risk taking, thus allowing the biotech group to reach a bottom more quickly. Biotechs went from highs to lows in four months, compared with the S&P 500’s 17 months.
In these situations of low growth and declining interest rates, biotechs typically outperform the S&P 500 Health Care index (XLV). This index is a good proxy for broader health care but not as much for biotechs as it is derived from stocks within the S&P 500 index. There were only six biotechs in the S&P 500 at last count.
The 2015-16 decline, like the present one, began in an environment of rising rates or expectations thereof. Rising interest rates tend to be harmful to biotech (and growth stock) valuations as they lead to a heftier discount rate applied to future potential earnings and diminish risk taking. In 2015-16, the biotech indexes fell between 40% and 50%, compared with a 15% decline for the S&P 500 and a 27% decline for health care.
In the present pullback, biotechs at the worst point had declined 65% and 41% for the two key indexes. This exceeds the maximum decline in 2015. During the 2015 period, the rise in rates began from the 0% to 0.25% range, just like the present one. However, the FED’s language was supportive and soothing, reiterating central bank patience and a rise in small increments at a measured pace. Biotechs reached their lows in that cycle in seven months. Presently, the S&P biotech index is 15 months into the decline and the Nasdaq Biotechnology Index nine months into it.
Health care has materially outperformed the broader indexes of S&P 500 and Nasdaq in the present pullback. However, one has to be careful when forming broad-based opinions about health care performance from the S&P health care index. It is a market cap weighted index and a top 10 holdings account for 55% of its performance. A few defensive groups within health care, such as pharmaceuticals, drug distributors and insurance, have done significantly better than most other groups and dominate the index performance because of their higher market caps.
A twist that muddies the investing waters
When the federal funds rate rose in 2015 from 0%, it eventually topped out at 2.5%. That is the level most likely to be reached in September after another three increases of a half-point each. Where the 2015 framework diverges from the present situation is that there was no inflation monster to slay at that time. This time 2.5% will very likely not be a sufficient rate at which the FED can stop.
The twist in the current scenario comes from the likelihood that even slowing economic growth numbers may not bring the inflation headline numbers down fast enough. This is because structural global imbalances are resolving rapidly but may take another year to start approaching normal and even longer to return to the desired 2% inflation target. This means that the FED, for the first time since the 1970s, will be placed in a position of considering tightening in the face of declining economic growth.
That is the risk being reflected in the market valuations. Biotechs in this environment cannot rely on the usual help from the combination of lower economic growth and falling rates, as this time interest rates will continue rising — hence the 60% decline in the equal-weighted S&P biotech index. The Nasdaq Biotechnology Index has declined 41% but masks the deeper industry decline, as it is a market-cap weighted index with the Top 10 companies accounting for over 50% of the performance.
The deep decline in the S&P biotech index can also be attributed to a surge in biotech offerings over 2020 and 2021 when nearly 160 companies became public through initial public offerings and special purpose acquisition companies. As per a McKinsey report, 66% of these had products and platforms in the early stages of preclinical or phase 1 development, a marked uptick in early-stage, higher risk offerings compared with those of prior years. Many of these companies may not be well prepared for the present environment of tightening financial conditions. Layoffs, closings and mergers and acquisitions are inevitable.
Investing in biotechs and health care
For the market to consolidate and rebound with consistency, it requires a step-down by the FED from its present aggressive rate increase strategy.
Such an opportunity could arise if the FED, after its increase in 50 basis points in September, concludes its series of half-point hikes and steps down to increases of 25 basis points thereafter. This will allow the FED to shift from a blunt force approach to a relatively measured, surgical one.
Although a much slimmer possibility, the FED may even decide to pause on further increases to evaluate the progress on inflation over the subsequent months if the financial markets are heavily stressed, inflation numbers are declining meaningfully, and the FED would like to guide the economy to a “softish landing.”
It is often said in the commodities market that a cure for high prices is high prices. If the FED believes so, then it will need to exercise patience later in the second half of the year, after a period of significant tightening, and allow higher prices as well to depress demand and contribute toward lower prices.
Even if only a step-down to
25 basis points materializes, and there is a good possibility for that to occur, it will set up the market for a strong fourth-quarter rally. The FED may begin to telegraph its intentions in late August or early September.
The current miasma of gloom shrouding the biotech group could dissipate rapidly in the late third quarter, and we may witness a rally of over 20% in biotechs during the final months of the year if the FED provides the right signals and tone in September. Of course, if the FED does not offer soothing signals as it gets to the 2.5% level, the biotech rally will be much more muted and selective as the indexes consolidate after a brutal shake-down. Mergers and acquisitions will inevitably grow later in the year as rapidly eroding biotech valuations attract mountains of big pharma cash.
With a 65% drop or about a two-thirds valuation erosion in the S&P biotech index, it would appear we are closer to a bottom than at any other time over the past few months. However, it may not mean a quick reversal but more of a consolidation around these levels and a slow grind higher till the FED relents.
Tarun Chandra, CFA, is an analyst with Graycell Advisors and Prudent Biotech. The original version of this article was published on Seeking Alpha.