What’s Next For Biotech And Healthcare • Prudent Biotech

The stock market has retreated sharply this year and quite relentlessly over the past few weeks. Biotechs have been in a retreat since late last year and the industry group is well into a deep bear market with valuations on the S&P Biotechnology Index (XBI) slashed by over 60% from its highs. In the Biotech Outlook, we discussed the uphill task that investors face this year. It has been very difficult thus far, but there will be selective opportunities to recover lost ground and perhaps record some gains this year.

Biotech valuations have fallen precipitously as the stock market encounters an environment it has 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 brief recession, is omitted.

Biotechs declined sharply in each of these pullbacks. The 2002-03 period is not as instructive since the Nasdaq Biotech Index (IBB) was started right during the middle of the decline, while the S&P Biotech Index did not exist.

What can be more insightful is to place these pullbacks in the context of a Federal Reserve interest rate policy reflecting the economic environment at the time.

During the first two periods, marked in green, the Federal Reserve was working to prevent or manage a recession by cutting interest rates. The biotech indexes dropped less than the market 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 quicker. Biotechs traversed the journey from the highs to lows in 4 months, compared to the S&P 500’s 17 months.

In these situations of low growth and declining interest rates, biotechs typically outperform the S&P Healthcare Index (XLV). This healthcare index is a good proxy for broader healthcare but not as much for biotechs since 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, just 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 it leads to a heftier discount rate applied to future potential earnings and diminishes risk-taking. In 2015-16, the biotech indexes fell between 40% to 50%, compared to a 15% decline for the S&P 500 and a 27% decline for healthcare.

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 0-0.25% 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 7 months. Presently, the S&P Biotech Index is 15 months into the decline and the Nasdaq Biotech Index is 9 months into it.

Healthcare 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 healthcare performance from the S&P Healthcare Index. It is a market cap weighted index and the Top 10 holdings account for 55% of its performance. A few defensive groups within healthcare, like pharmaceuticals, drug distributors, and insurance, have done significantly better than most other groups and dominate the index performance due to their higher market caps.

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 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 the 2.5% rate will very likely not be sufficient for the FED to 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 due to structural global imbalances that are resolving rapidly but can take another year to start approaching normal and even longer to return to the desired 2% inflation target. This means that the Federal Reserve 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 usual help from the combination of lower economic growth and falling rates, as this time the interest rates will continue rising. Thus, the 60% decline in the equal-weighted S&P Biotech index. The Nasdaq Biotech Index has declined 41% but masks the deeper industry decline since 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 came public through IPOs and SPACs. As per a McKinsey report, 66% of these had products and platforms in the early stages of preclinical or Phase I development, a marked uptick in early-stage, higher-risk offerings compared to prior years. Many of these companies may not be well prepared for the present environment of tightening financial conditions. Layoffs, closings, and eventual M&A are inevitable to shake out the surplus of weaker players.

For the market to consolidate and rebound with consistency, it requires a step-down by the Federal Reserve from its present aggressive rate increase strategy.

In our opinion, such an opportunity can arise if the FED after its 50 basis point increase in September concludes its series of half-point hikes and steps down to 25-basis point increases thereafter. This will allow the FED to shift from a blunt force approach to a relatively more 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, after a period of significant tightening, and allow higher prices as well to depress demand and contribute towards lower prices.

Even if only a step-down to 25 basis points materializes, and we believe there is a good possibility for it 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 and early September.

The current miasma of gloom shrouding the biotech group can 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 Federal Reserve 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. M&A will inevitably grow later in the year as mountains of cash at big pharma are attracted towards rapidly eroding biotech valuations.

With a 65% drop or about a two-thirds valuation erosion in the S&P Biotech Index, it would appear that we are quite close to a bottom than at any other time over the past few months. However, it may not mean a quick reversal, but more of consolidation around these levels and a slow grind higher till the FED relents.

Biotech investments should be presently limited to well-funded companies with more advanced Phase II and III drug candidates with upcoming results over the next 6 to 12 months, companies reporting strong clinical data, and those that are finding commercial success with new and existing drugs. Other than targeting such companies, patience on the sidelines can be an effective strategy for the time being for most biotech investors. Of course, biotech is a speculative area and investors may find something attractive that is now a fraction of what it was worth. Such investments are more of a personal risk profile based choice.

Healthcare remains the defensive sector of choice. If some help from the FED is forthcoming later this year, leadership will rotate from pharmaceuticals to more growth-oriented industry groups like medical devices, systems, and services.

The Prudent Biotech model portfolio got caught in the January slide and has dropped more than 30% this year, even though it outperformed last year with a gain of nearly 50% compared to a loss of 20% for the S&P Biotech. The Prudent Healthcare model portfolio is down 20% compared to a 5% decline for the S&P Healthcare index. Last year, this healthcare model portfolio gained 64% compared to the index’s 24% rise.

A major oncology annual conference, ASCO, gets underway from June 3-7. Many biotechs provide clinical updates and at times partnerships and an occasional M&A transaction are announced as well.

(The article was first published on Seeking Alpha)