Biotech Sector Running Hot, But the Heat May Not Last

Biotech Stocks

It should not surprise us that among the good performing sectors this year, the biotech sector is among them, in the midst of a pandemic. Returning to normal isn’t so rosy though.

When we focus on a particular sector among a broader stock index, such as the iShares Nasdaq Biotech ETF as a component of the Nasdaq itself, we at least need the sector to outperform and also have a better outlook to do so in order to make any sense of going with this narrower group of stocks.

Biotech stocks are getting plenty of attention these days as we continue to find ourselves in the grips of the COVID-19 pandemic, and although the crisis has abated in several other regions of the world, it remains alive and well and very present in the United States at this time, even though it is still being misportrayed shamelessly by popular media whose goal is not to inform but to scare.

While we’re coming to understand more and more that this pandemic can only be expected to resolve by way of natural forces, by virtue of its unstoppable march towards saturation. The only thing being shown to curb it is time, and it being curbed by time elsewhere with this expected to manifest in the U.S. as well with a little more time. There is still quite a bit of talk out there though about the role that treatments and vaccines may play going forward, and this causes companies such as biotech firms to receive additional support and optimism.

There’s always some guesswork involved when projecting these things, but at the same time there have always been strong reasons to believe that by the time we ever come up with a biotech solution to this, this show will likely have at least wound down to the point that this really isn’t going to matter, if not gone entirely.

Whenever we look to invest in something, to do this successfully requires that we maintain a sound mind and countenance and take all factors that may influence our decision into account. Rather than being afraid and overreacting to the situation and then seeing biotech companies coming to the rescue, we need to take a more honest look at how wise all the spending that these firms are making may be and especially account for the greater risk that these companies take on.

It’s fine to ride any wave of momentum with stocks, no matter how valid or invalid we think it may be, as the invalid stuff provides profits that spends just as well. It is important to have an idea how long something might last, not because we want to be guessing about when it ends, as we need to allow reality to tell the narrative itself, but the more sand there is in the foundation of these moves, the quicker we need to be to run when it starts raining.

There are two main elements that need to be considered when looking at stocks or stock sectors, which are the potential they offer us for gains and the risk that is involved in seeking these gains. Biotech stocks certainly do move in the right direction pretty well at times, and this is indeed one of those times.

We need to realize that this really only happens with certain biotech stocks, the ones that catch fire, although these stocks can burn up pretty fast as well. Investors are often full of hope, but this hope does not spring eternal and they can turn their backs on these stocks on a dime, when this hope diminishes and their stock gets smacked.

While investors generally diversify way too much and in a way that is far too indiscriminate, choosing a lot of bad to spread out risk that just adds to the effective risk of the plan, putting too much of your money on boom or bust stocks is an excellent example of not enough diversity, although there are stocks that you can do extremely well with this but only those with both a big upside and low effective risk, and we will explain what effective risk is later in the article.

Biotech stocks face business risks that are well in excess of your average stock, which includes not only failures but their failing to come up with the next big thing often enough. This much higher business risk translates to their stocks as well, and actually gets amplified by the stock market just like they amplify the prospects of business growth into stock prices that can run much faster than earnings growth.

This is why people tend to turn more toward groups of stocks in the same sector, such as the Nasdaq Biotech Index, to spread this extra risk around more. Often times, with an index, it can really pay to be selective with it, to cut out the weak and keep the better, but looking to just buy the whole thing is a whole lot easier, with no real skill required other than just picking the right sectors.

We’re going to compare this biotech index with the bigger index it comes from, the Nasdaq itself, to see how this particular cut has fared and may be expected to perform going forward.

If we are only vaguely familiar with the Nasdaq Biotech Index, and not a lot more familiar with the Nasdaq itself, we might think that these biotech stocks run better when they are running with perhaps not a lot more risk, as the Nasdaq is perceived to be pretty risky by a lot of investors, who neither have bothered looking or even understand risk that well.

If we’re going to only cut ourselves a fairly small piece of the Nasdaq, we do need to make sure that it’s tastier than the big pie, and doesn’t cause us a whole lot more indigestion. We need to ensure that the whole package, both their rewards and their risk, cashes out to something better and not worse.

People may remember some biotech stocks that took off like a rocket, and not realizing that this really isn’t that common among these stocks, and they also don’t tune in for the rest of the story which doesn’t always end so well. Biotech stocks in the aggregate actually isn’t all that much to get excited about as far as their upside goes, as we will see when we have a look at how this index really performs.

The big pie will be the reference point, as to make sense of going with just a piece of it, the piece has to be better. If it is clearly worse, you will either need to find a better piece, one actually better than the pie generally, or take the easy way and just buy the whole pie.

We don’t even have to look at much data at all to discover just how inferior the biotech is to the main index. The biotech index is like dribbling a basketball, mostly up and down without being raised off the floor very much, perhaps being picked up at waist level here and there before the dribbling starts again. The Nasdaq, on the other hand, is like throwing up a three-point shot and hitting all net.

Looking at the 5-year chart of the iShares Nasdaq Biotech index, we do see a lot of dribbling, with move that might look like it does move when you look at it on a shorter scale, just seeing the bounce off the floor and back into our hands, but when you widen the scale, you get to see the actual dribbling, how it goes back down and then back up again a number of times.

The Broader Index Simply Embarrasses This Narrower One

The net gain over this time has only been 10.7%, a positive return but not a very impressive one, not even a desirable one, especially compared to the 231% that its big brother the Nasdaq has moved up over these 5 years. This is like comparing an NBA star with the team’s ball boy.

This is worth breaking down a little more to show that this isn’t just a product of some isolated event where biotech managed to beat it for at least some of this period, to an extent where we could perhaps figure out when this may be happening, when biotech is in an uptrend and beats the big index over this time but gives up too much on the way down and this may allow us to fashion a plan where this index may be competitive at certain times.

Even if we do find such a thing, getting beat on a score of 23 to 1 without having to do anything in itself tells us that we’re comparing men with boys, and given such a divergence, it would be extremely unlikely from a statistical perspective that we would find much opportunity at all, let alone one that would show itself well enough under a system of rules we could design to benefit.

For example, we might see a year where biotech actually beats the Nasdaq, 1 out of 5 we’ll say, but it is not enough to just cite this. We are looking for things that may have predictive value, where we need rules that have not only shown to have this but have done so enough times to be reliable. We just won’t be finding anything of this sort with such a wide divergence in performance, but we will look anyway so we can really throw dirt on this idea.

The only real time that the biotech index even had the potential to beat the Nasdaq over this time, other than this year, was back in 2016, when this index put in a quadruple bottom. Three times it tried to go below $83, and three times it hit the floor and bounced back for another dribble. We would normally want to see it break out of this pattern, but we’ll even assume that when it hit this area the fourth time you just decide to jump in even though this would be premature, to put the very best face on trading this we can.

You get in at $83.90 at the exact bottom on Halloween of 2016, and you aren’t just trading based upon your own skills, you have a genie who grants your wish and goes ahead in time to 2020, prints a chart of this index, and goes back to 2016 and gives it to you. The genie smiles at your thinking that you can beat the Nasdaq with this chart and invites you to have a go.

You don’t have the chart of the Nasdaq and even though you know that it does better, surely having the chart of the biotech index in your hand and knowing the exact day of the top of this move, August 27, 2018, where it drops off sharply from there, sure seems like a supernatural advantage.

You sell it on the appointed day and get $122.19, the very top, and make 45.6% in less than 2 years and are very happy. Trading with a genie sure is great, you think, and you ask your genie if he took this trade as well, knowing it was so good. The genie tells you that he invested in the Nasdaq instead since it’s always better and didn’t even need a future chart to do this, and has beaten you with his 64.2%.

This is not a huge difference by any means, but shows that even having the future laid out before your eyes isn’t enough to win this game, and we certainly don’t have charts of the future to rely on. Sitting at our desks today, we do have this chart now, and see that biotech has gained another 11.9% since that day in 2018, while the Nasdaq has added 32.7%. We can’t even get a fair match taking the best scenarios with the biotech index and still expect to win a game against the Nasdaq squad.

Some might raise their hand and think that we need to look at 2020 when biotech really had the opportunity to shine. Maybe we want to come up with a rule that you go with biotech during genuine pandemics, and we’ll even leverage our genie who whispers in our ears at the start of the year that a pandemic is coming and gives us the opportunity to choose which side we want.
This would be the dream match for biotech if there ever was one, a chance of a lifetime even, especially when we are told back then that we’re going to shut down most of the economy and this will cause depression-like numbers with everyone hunkering down and waiting for a biotech solution to save them.

We think that the Nasdaq will simply get hammered with this, and since we don’t understand risk much, we already are probably thinking that the Nasdaq is riskier than the other major stock indexes and will take an even bigger punch. Meanwhile, with the world holding its breath for biotech, people will be taking money out of other stocks and putting more in ours.

Someone will be paid handsomely to save us, and since we own the whole index, we are very happy that we are this well diversified when we’re told by the genie that there will be many companies competing for this pot of gold at the end of the rainbow. We don’t care which among our biotech stocks gets this gold because they are all ours, and we then wait with excitement while the whole thing unfolds.

We then get transported to today, and look at our account and see that we’ve made 12.8% so far from this investment when just about everything else is down. We look at the S&P 500 and see that it is down 4% instead, and have therefore beaten it by almost 17% so far. We also look at the Nasdaq to see how much we beat that index and our smile turns upside down when we see that we’ve lost again to this team, 15.4% to 12.8%. Even a once in a lifetime dream season like this, a scenario so good that we could not even have dreamed it, with our side being helped so immensely and their side being challenged so immensely, still has us behind.

It’s Better to Be Guided by Understanding Than by Fear

In spite of how much the biotech index is humbled by their relative lack of performance, we still need to look at the risk side, but we don’t just want to do that in terms of drawdowns, how far something fell from top to bottom. People think that the Nasdaq is riskier than the S&P 500 or the Dow because they see the Nasdaq go down a little more at times, although even this is a false belief as the Nasdaq does not go down more by a meaningful amount as is believed.

Drawdown risk is actually far less of a concern with the Nasdaq because its better performance creates a buffer between these indexes, where if it goes down by a couple of percent more in a selloff than the S&P 500, you might think that this is a negative until you step back and look at the bigger picture. If you have gained 10% more over a given period of time and then gave back 2% of this, this has you not down 2% but ahead by 8%.

Investors misunderstanding this principle of understanding risk dynamically is at pandemic levels, and all you have to do is go out there in the world to try to find a good discussion of this to see the extent of this infection of misunderstanding. We’re sure that we’re not the only ones that get this, but we’re not aware of anyone else teaching this, and we spend a lot more time looking at the ideas of others than investors do.

The reason why we call this an infection is that this should actually be pretty transparent, where someone might say that Apple is too risky for their blood, being scared by their bigger pullbacks, and miss the fact that at the worst of times they are still left phenomenally ahead of all the major indexes including the Nasdaq.

This is like saying that they could have bought a stock at $100 and saw it go to $300 and then back to $200 and somehow see themselves losing $100 a share instead of making it. This is nothing like the main character Will from the movie Good Will Hunting telling one of the world’s brightest math professors that ingenious mathematical solutions that the professor has struggled with so much come so easy to the prodigy.

In our case, we’re only dealing with things that are taught at the grade school level, if not before, things like if you start with $100 in each of your two pockets, where you lose the $100 in one pocket but end up with $300 in the other, you should at least count what’s in the other pocket to see how much money you made or lost overall.

When even the simplest of reasoning collides with fear, it’s a mismatch, and reasoning just gets bound and gagged. If the examination starts and ends with the missing money from one of the pockets, and doesn’t even care to look at how the money in our other pocket has grown, then your fear will certainly have you not wanting such a thing no matter how beneficial this may be for you.

This misconception of risk has us do all sorts of crazy things, where we fear the empty pocket so much that we will stuff both our pockets full of junk and even things that are more likely to lose money for us than make it. The better the opportunity, the more afraid we tend to be, and the more prone we are to be frightened by this drawdown risk, the more we will be driven away from the best or even better in favor of the much lesser, where we see the lesser opportunities as safer when the opposite is true.

We can imagine the trembling hands of investors suitably confused if we put a gun to their heads and told them a few years ago that they are to put all of their money in Apple stock, and we’re not talking about going all the way back where we would have gotten 4 digit returns, we’re speaking of a time where these investors already thought that the stock was in “nosebleed” territory, like back in early October of 2018 for instance.

In the prior 10 years, since the start of the bull market, Apple had already gained over 2000%, and if anything were to cause your nose to bleed, this would be it. The noses of investors only bleed when they are afraid though, not when a stock has moved up any amount.

We want to make this more dramatic than usual so we’re going to tell these investors on the other side of our gun that they are not only forced to put all of their portfolio into this nosebleed stock, we’re forcing them to hold it through both the bear market that is right ahead plus a bigger one in 2020 where the world suffers the biggest pandemic in 100 years and we shut down most of the economy.

To make this even more frightening, we’re forcing them to sell on July 1 of 2020 in the midst of this pandemic, with a loss of economic growth so severe that it doesn’t even stop at levels considered to be a recession but keeps going into depression territory where they get dropped off.

We tell them that we will spare them the pain and grief of their seeing these alleged horrors unfold before their eyes and we will instead instantly transport them to today and then put our guns away and untie them. Much to their surprise and delight, they discover that through all this, they are up right now by 65% in the year and 9 months they were in the stock, and hopefully come to a realization that they really didn’t understand much about risk after all as they get to view the big picture.

Risk and fear are indeed two separate things. If they take this idea and run with it, they will soon be able to see why the S&P 500 is actually riskier than the Nasdaq, and it’s not because the S&P moves down more, it is because it does not go up enough to offset these moves down when they do happen. Where you end up actually does matter, a simple insight but one that is so lacking. They now hold the key to understanding risk, not at any sort of advanced level but at its simplest level, the one that has us checking both pockets when we count our money.

Successful investing is much easier than we think, and doesn’t even require all that much thinking at all, but does require that we think about the right things. If we look at this biotech index and think that this is a good place to keep our money versus in the bigger index that it is a part of, we are not thinking about the right things, and in this case, not even thinking at all. A little thinking can go a long way.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

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