Last summer we traded the biotech space successfully. We
bought IBB between $259 - $261 and scaled out for a profit between $285 to $297
between July 1, 2016 and August 24, 2016. We accomplished the same trading LABU
buying in the mid-$20’s and selling in the upper $30’s.
There are a few reasons why I anticipate getting back involved
with the biotech space soon.
Seasonality
The first point I should make is the seasonality of the
biotech sector. According to research done by Tom Bowley from Stockcharts.com,
“During MarketWatchers LIVE on Wednesday,
I discussed seasonality and mentioned that for the months May through July, the
Dow Jones U.S. Biotechnology Index is the best performing industry group over
these three months. Below is the history by calendar month for the group:”
“July averages gaining
4.3% over the past two decades. May (+1.4%) and June (+0.6%) are also
historically strong months. So while the DJUSBT faces technical
challenges (primarily major price resistance near 1800), it will not hurt to
have historical tailwinds as we approach and enter the summer months.”
Technical Analysis
On the daily chart for IBB biotech ETF, we see an ascending triangle
pattern that has developed and this is usually a bullish pattern. A break-out
above $300 is an entry point for us. We’ll buy some IBB and perhaps the 3x
levered (very volatile) LABU.
On the weekly chart, we are also seeing bullish
developments. We see a bullish cup and handle formation with the break-out
level above $300. This provides us further confidence of a potential trade in
the works.
The point and figure graph is also exhibiting a spread
triple top formation within a bullish P&F pattern. Most times this will
represent consolidation and then continuation of the previous trend. It’s in a
bullish pattern now so a break-out to the $304 level may see the continuation
of the bullishness we’ve seen thus far.
Fundamental Analysis
Looking at both price to sales ratio and price to earnings
ratio, the quant team at BAML has pointed out that the biotech sector is trading
at multi-year lows relative to average valuations. A large part of this is due
in part to the political environment that has placed the drug sector in a
negative light. We agree with the analysis by BAML that most of this negative
news is already reflected in asset prices and we believe any bit of good news
on the political front, i.e. tax reform, repatriation or reduced regulatory
burdens could be the fuel to drive this sector much higher.
Relative to the expected earnings growth in the coming year,
GARP investors are probably watching this sector very closely. In this environment,
it is difficult to find a sector offering potentially 15% forward earnings
growth trading only 13x forward earnings.
They also make a point to show how underrepresented this
sector is with large institutional investors. Once the political backdrop
clears, we would expect rather large fund flows to find its way into the
biotech space.
Political Update
According to a recent article in SeekingAlpha,
“Investor sentiment has been poor for
several years, and it seems that with Trump policies there could still turn out
to be some pretty scary headlines ahead.
An examination of the
charts for the biotech indices and immunotherapy ETF CNCR, however, provide
some insight into current sentiment. Two years of index corrections should have
already compensated for a reduction in corporate profit.
As reported by Fierce
Biotech in March, President Trump reiterated the need to repeal Obamacare, but
emphasized that the FDA process is too slow:
“But some of his
toughest words were reserved for the FDA and the drug approval system, which
for months now he has signaled is too slow, and could very soon be about to get
a new, and possibly radical, commissioner.”
Meanwhile NPR reported
on the options that the Trump administration has to tweak Obamacare, without
requiring the help of Congress.
Analyst Michael Yee
reported that cutting approval time could itself reduce industry costs, as well
as increasing competition by moving Medicare from Part B to Part D, he also
made the valid point that potential Biotech company profit reductions have
already been priced in:
The "bottom
line" is that biotech investors are looking at how bad it's been over the
past year, but a lot of that movement has already been priced in, Yee said.
Trump's policies won't result in a "worst case scenario" for the
sector, he reiterated.
For example,
Republicans could choose to go a number of routes to slash drug prices,
including: cutting the patent life of drugs shorter to increase the pathway to
generics, moving Medicare from Part B to Part D or accelerating more drugs to
be approved faster, Yee said. All three would increase competition in the
market.”
Joseph S. Kalinowski,
CFA
Email: joe@squaredconcept.net
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/
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