Biotech investing can be challenging for several reasons. Medical research and development is prolonged, undiversified and usually unprofitable for extended periods.
On a risk-adjusted basis, biotechnology has one of the lowest long-term returns in the market. However, like moths to a flame, investors keep coming back in hopes of picking the next 1000% winner.
Investors tend to overemphasize the big winners in the biotech sector because they benefit from survivorship bias unlike any other group. There are a disproportionately large number of unprofitable “development stage” companies in this sector that are either going to bring their products through the process of development, approval and marketing or not.
If a company can’t make it through that process, it goes away, which makes the historical data (that only includes the survivors) look misleadingly positive.
Since so many of the products developed within the sector are novel, analysts are usually just guessing about the viability in the future. The combination of survivorship bias and uncertainty tends to amplify volatility within the sector.
Volatility may be a good thing for short-term traders who try to take advantage of that, but it also leads to a sector that can get a little “frothy” and overheated on a regular basis.
Accurately identifying a frothy market that is about to pop is a challenge, but there are a few key characteristics that can help clarify things. In our opinions, the biotech market is looking too hot right now — so, this is a good time to discuss this analysis.
Development-Stage Biotechs Lead Lower
Biotechs in the developmental and/or clinical trial stages are good “canaries” in the biotech coal mine. As you might imagine, unprofitable firms with few or no products on the market are usually the first to turn lower when their sectors are overvalued and due for corrections. In the biotech world, those downturns can be pretty quick.
Traditionally, we have just evaluated a manually constructed index of developmental (unprofitable) biotechs for this kind of analysis. However, there have been some recent exchange-traded funds introduced to take advantage of the rush into the sector (another common symptom of an overheated market) that can serve the same purpose.
In the future, the Bioshares Biotechnology Clinical Trials ETF (NASDAQ:BBC) looks promising as a proxy for this kind of stock once it develops a longer history.
In the chart below, you can see the iShares Nasdaq Biotechnology Index (ETF) (NASDAQ:IBB) that sold off in early March 2014. This ETF is much more broadly diversified than BBC, and its largest holdings are profitable, established biotech stocks.
The selloff in IBB was preceded by unprofitable biotech stock indexes that broke support as a group in mid-February. This was one of several recent cases, where the most speculative biotechs warned of a broader decline in advance. We think there are some early warning signs that low-quality biotechs are starting to selloff right now.
iShares Nasdaq Biotech ETF (IBB): Chart Courtesy of eSignal
Blowoffs Signal a Halt in a Trend
Because the biotech sector can be a hot market, it’s common to see blowoffs at the end of a trend. A bearish blowoff is defined as a dramatic increase in price (often over just a day or two) with very high volume that appears after the market/index has already seen significant short-term gains.
For example, in the next chart, you can see how the Bioshares Biotechnology Clinical Trials ETF spiked last Friday accompanied by volume that was much higher than average.
Bioshares Clinical Trial ETF (BBC): Chart courtesy of eSignal
From a technical perspective, a blowoff is more of a “risk control” signal than a strong trend-change indicator. However, we think that in either case, its occurrence is a strong warning in a fragile market.
Nervous Traders Start to Hedge
The options on biotechnology stocks/ETFs can also give us some important insight into whether biotechnology is getting a little too hot. When traders get nervous, they hedge.
We would expect short-term, at-the-money, put-option buying to increase when investors are afraid, which is exactly what we can see right now in the major biotech indexed ETFs.
For example, the at-the-money, standard April put options on IBB have 3200% the open interest of the equivalent calls (see image below), which is an imbalance that we can see to a lesser extent throughout the chain sheet.
Across the board, twice as many puts on IBB have been sold at the ask price as the bid price so far this month, which means that most of that open interest are probably put buyers. You buy a put when you think a stock will fall or want to protect a long position.
IBB Option Open Interest: Source – CBOE.com
Conclusion
It’s important to note that we can’t prove a sector is going to selloff before the fact. However, we can look for common issues that have appeared in the past before significant corrections. From that perspective, biotechnology looks overheated. If biotechs decline in March and April, we would expect the drop to be larger than average.
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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