The big news items Wednesday were, of course, the FOMC’s rate announcement and its economic projections. The short story is that a rate hike (or two) is probably still in the cards for later this year. However, the statement continues to hinge on the contingency of economic data.
The impact of the FOMC’s announcement will not be clear for several days, as investors “read the tea leaves” and try to integrate the announcement with other issues like those surrounding Greece. Consensus will probably take a few days to really solidify, and this is a good opportunity to discuss how investors use consensus market-estimates (as opposed to analyst estimates) to create forecasts and prioritize one opportunity over another.
One of the best sectors to illustrate this concept is pharmaceutical stocks. The number of unknowns that can dramatically affect this group is unique compared to most other categories.
We would define the pharmaceutical group fairly broadly, from traditional drug-makers like Pfizer (PFE) to distribution like Rite Aid (RAD). While on the surface they all look likely to benefit from the Affordable Care Act, also known as Obamacare, the advantages are not necessarily going to be evenly distributed.
Many of the benefits of increased healthcare spending can be offset by confounding factors that vary widely from one stock to the next.
For example, although the dollar has been rising or flat since March, the impact of currency translation is still hard to forecast for pharmaceutical companies. PFE lost 7% in its most recent quarterly report from translation issues, while Johnson & Johnson (JNJ) lost 7.2% to translation. Is that 0.2% enough to account for the dramatic underperformance in JNJ compared to many of its peers? Probably not.
Pharma companies are very tricky for fundamental analysts. Besides the issue with currency translation, these companies are subject to significant patent expiration, development and regulatory risks that are unique to this industry. Add in the impact that interest-rate policy can have on the value of the larger-than-average dividends paid by these companies to the equation, and you have a recipe for uncertainty.
Technicians will counter that there is a way to deal with this industry that does not require expert knowledge of the pharmaceutical industry, chemistry or currency analysis by focusing on the consensus of the crowd.
One way to understand how this works is by thinking of the old county-fair game of guessing how many beans are in a jar. If the average guess for how many beans are in a jar is compared to the actual number, it tends to be remarkably accurate. However, the individual guesses are almost always inaccurate.
Jack Treynor, the famous financial economist, once ran the “beans” experiment on a large class of students. The average guess was 871 beans and the actual number was 850, which is remarkably close. However, only one student was able to make a more accurate individual guess.
The markets are actually a lot like this class of students. Each participant has higher or lower estimates for the value of future patents, drug marketing plans, currency changes, acquisitions, etc. But we would assume that the average of these guesses is relatively close to the actual value of those factors and more accurate than the individual estimates.
In the market, the “average guess” is the current price of the stock. Both fundamental and technical analysts will use this basic idea to make better forecasts about the potential for a stable trend through relative strength.
For example, so far this year, PFE has outperformed JNJ, AstraZeneca (AZN), GlaxoSmithKline (GSK), Merck (MRK), AbbVie (ABBV) and, when adjusted for volatility, Bristol-Myers (BMY). The consensus estimate is that PFE’s unknowns are more valuable and stable than its peers.
We can’t make specific claims about PFE’s patent cliff versus JNJ’s because there are too many unknowns about what has already been priced in and whether the information we have now is accurate or not. However, over the long run, stocks that have been outperforming the average of their group tend to continue to do so.
Ignoring the fundamentals is not always a good idea. Not all sectors are as uncertain as pharmaceuticals, but the principles of relative-strength analysis should still be applied to supplement fundamental analysis and, in many cases, they help to confirm the fundamental factors.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
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