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When the economy is emerging from recession, the markets tend to gravitate towards “Early Cycle” themes. These are the segments of the markets that are the first to feel the benefits of an uptick in economic activity. Semiconductor and related technology stocks are one part of the “early cycle” segment of the market.

To that end, investors will watch for the technology stock laden NASDAQ to begin to exert leadership over other broad market indices such as the S&P 500. As the chart below shows, the NASDAQ began to outperform the S&P 500 almost five months before the S&P 500 made its bear market low.

It would stand to reason then, that this would be because the market was able to factor in the idea that the economy would begin to bottom, and early cycle stocks were a good place to be. However, a look at the facts gives a somewhat surprising reason for the outperformance of the NASDAQ over the S&P 500.

Biotechnology stocks, which comprise a significant portion of the NASDAQ’s market value, but are less than technology stocks, are not typically thought of as early cycle stocks. Yet, they have been quietly outperforming the market for quite some time. In fact, even before the financial crisis began to make waves, the outperformance of the biotechnology stocks against semiconductor stocks (Figure 1) and the broader market (Figure 3) were already underway.

Surprisingly, the semiconductors, which should be outperforming the NASDAQ, are thus far underperforming (Figure 2). Put another way, Figure 2 shows that the NASDAQ is outperforming computer chip stocks.

(Click to enlarge)

However, investors should be careful with this sector, as it can be exceptionally volatile. The last two years have seen a great deal of merger and acquisition activity, as the large pharmaceutical companies have looked to smaller biotech companies to help refill their product pipelines. The largest biotech company is Amgen (NASDAQ:AMGN), with a market value approaching $60 billion. Despite this strong outperformance, the biotech sector seems to be attracting very little attention from many investors.

In addition, the current healthcare debate has left the markets trying to grapple with who the winners and the losers will be if and when healthcare legislation is passed. The thinking amongst some market analysts is that as the number of individuals who will qualify for medical coverage increases, as a result of the healthcare reform bill, the industry will benefit. In addition, certain provisions of the healthcare reform bill will allow biotech firms to receive twelve years of competitive protection from lower cost, generic competitors. This should prove beneficial to their profit margins.

In light of this weekend's historic healthcare reform vote in the US, investors may want to give this forgotten sector a second look.

Disclosure: No positions

Source: Biotech Stocks: The Unappreciated Drivers of the NASDAQ's Leadership