Since achieving their 52-week highs in late February/early March, biotech stocks have arguably been battered more than any other sector during the recent downturn. While the sector had clearly gotten ahead of itself and the valuations of the underlying stocks were unsustainable, we believe that traders and investors who dismiss these shares over the next month or so could be soundly kicking themselves.

From recent peak to recent trough, the bellwether biotech ETF, iShares NASDAQ Biotechnology Index (NYSE—IBB) dropped by about 25% in just a few short weeks. It rebounded last week to close 7% above its low, which occurred on April 15.  It closed at $222.16 which is technically important and bullish because it closed above its $220 200-day average.

Still, it is not the close that has us bullish per se. Trading could be erratic and it could easily trade below this (declining) DMA, although I think it is more likely it bounces back toward the $250 range, which would be the 50-day moving average.

Instead, there are reasons why we believe the sector will do surprisingly well.

First, judging by recent trading activity, we have reached the all-important capitulation phase, where weak holders and profit-takers have exited, limiting selling pressure. We see this just in the volume. For the fist 13 trading days of April ending on Thursday April 17th, a total of roughly 56 million shares, or 4.3 million shares per day of IBB have been traded. That is a 72% jump as compared with the 2.5 million average daily volume, or a total of 52 million shares through 21 trading days in March. Of course we could see still see sharp declines, but by our account, the worst is over. 


Truth be told, the IBB ETF represents the top tier biotechs so it is natural to assume that this group would sell off (or be shorted) first. As if on cue, while the IBB was recovering, a number of low-mid tier biotechs endured a wave of selling.  We view this event as a confirmation of our capitulation stage thesis.


Figure I. IBB Moving Averages, Change, and Volume
Source: www.BarChart.com

We are nearing the  month of May which will mean that the “Sell in May and Go Away” crowd will soon be out in force.  That factor alone could make it hard for any stocks, let alone biotech to get some consistent traction. Nonetheless, a major event in the oncology world begin in late May and it is typically a driver of oncology-related biotech stocks just prior to the conference. Barring a broad-based decline, we envision a modest  pick-up in this segment of biotechs, with the aid of the American Society of Oncology Conference. 

Ahead of this backdrop, word that Pfizer (NYSE—PFE) is considering buying AstraZeneca (NYSE—AZN) for $100 billion has got to give the space a near term shot in the arm as well.

Therefore, we recommend buying small oncology names or perhaps longer term calls on big pharma if in fact the buyout rumors are true as it could prompt a re-valuation of the sector.

To Ponder and to Monitor

This week is an important one for those that closely monitor earnings season.  There are not too many interesting names reporting on Monday aside from Netflix (NASDAQ—NASDAQ) and random health care firms.  Amgen (NASDAQ—AMGN), AT&T (NYSE—T), McDonald’s (NYSE—MCD) will have a very real impact on stocks midweek following their results on Tuesday (mainly after the close.)

We still maintain that with a FY14E P/E of around 19x for the Russell 2000, most small caps are still expensive, while the S&P 500 is getting more reasonable, on a valuation basis. Still, aside for the short term biotech play, select consumer stocks, which are already expected to report a poor Q1 could end up being  decent performers.

A very interesting and out of the box stat to monitor is web traffic to investment related websites.  When stocks are doing well, traffic rises, when it is not, traffic declines. This can be monitored in real-time and makes sense. Most websites are visited by individual investors and when they are keenly engaged in trading and investing (which occurs in bull markets not corrections or bear markets), traffic is up. In down markets, stock trading and web activity are both reduced. Interestingly, with the exception of when we initiate coverage of a new stock or write about a widely held small stock, I can gauge investor trading activity to some degree by our own website traffic. We will consider engaging this metric going forward.

Speaking of corrections, while biotechs corrected to the tune of 25%, both the NASDAQ Composite and the Russell 200 Index nearly hit  a correction of 10% midday last week. Both reached the 9.7% decline point before bouncing back with a vengeance, and were up over 3% from their lows. This is very bullish near term and also affirms our capitulation phase but we are not out of the woods and could still reach the 10% or more correction number which we view as healthy and required to return to a favorable valuation for growth stocks.

Have a great week!