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It's a poorly kept secret that healthcare stocks in general, and biotechs in particular, have been some of the best performers over the past two years. Companies like Acadia Pharmaceuticals (NASDAQ:ACAD), Intercept Pharmaceuticals (NASDAQ:ICPT), and Epizyme (NASDAQ:EPZM) have captured the imaginations of speculative investors with their voracious movements upwards, lifting the entire sector as a result.

Indeed, dozens upon dozens of developmental stage biotechs have soared of late, as speculators have piled in, hoping to find the next home-run in healthcare. Like most dreams based on sheer delusion, however, it would appear that the healthcare party is also coming to an end.

A central theme throughout my recent articles has been the frothy nature of developmental biotechs, and how investors have eschewed things like actual earnings for whimsical concepts like "potential market size". As such, I've tried warning investors off of companies with no approved drugs burning cash at light speed in clinical trials. But delusion is a powerful mistress.

In the meantime, companies like Acorda Therapeutics (NASDAQ:ACOR) have watched their earnings steadily grow but their share price stagnate. The same can be said for Questcor (NASDAQ:QCOR), as well as a number of other biopharmas trading at historically compressed multiples. Put simply, investors have largely not rewarded companies doing actual business, and thriving at it. Odd, right?

By contrast, we have watched in amazement as companies with Mt. Everest types of deficit levels, like MannKind Corp. (NASDAQ:MNKD) and Acadia, rip higher, despite not having any significant form of revenue. And if the truth is told, the only revenue for these types of companies has come in the form of selling stock, meaning they have been selling hype.

Well, I think the day of reckoning has come, and I'll share some data from yesterday's session to illustrate my points.

Point #1 Smallish to lower mid-cap biopharmas have been the best performers in general over the last two years. So, I would expect them to take the biggest hit on a correction.

Taking a look at yesterday's session, we see some interesting trends backing this assertion. First off, 66% of large cap pharmas ended the day in red. However, small and mid-caps saw declines exceeding 80% for their respective market caps. So, the sell-off was more pronounced in last year's biggest winners.

Point #2 Investors will 're-discover' earnings this year, and shun potential. As a result, I expect small cap pharmas to crash this year.

Looking at the tale of the tape yesterday, we see that both maximum and average losses increased with decreasing market cap in the healthcare sector (see Table below). What's particularly interesting is that small caps like Cell Therapeutics (NASDAQ:CTIC) crashed on no news. By contrast, we didn't see any major nosedives in the mid to upper large caps. Declines yes, but nothing to panic over.

Market Cap

Biggest Loser 1/27/14

Average loss

Large

Regeneron Pharm.,-3.17%

1.14%

Mid

Align Tech., -5.86%

2.06%

Small

Cell Therapeutics, 16.5%

3.45%

Bottom line: Investors are rotating out of last year's favorites and into more defensive plays. Consequently, the market looks to be correcting for the hyper-delusion of biotech potential and returning to its historical behavior of assigning value based on fundamentals. I see that as a good thing.

Based on this theme, my favorite names in the sector for long plays are Amgen (NASDAQ:AMGN) and Gilead (NASDAQ:GILD). On the converse, I think most small caps are going to struggle this year, making them ripe targets for short plays. Don't be surprised if a number of the small caps that doubled or tripled in 2013 give back most of those gains in 2014.

Simply put, I expect small cap biotechs to crash this year under the weight of the global financial milieu, combined with their recent face-melting gains. Large caps with newly launched products appear to offer investors a safe haven, especially those with potential blockbusters on their hands, ahem Gilead.

Good luck!

Source: Is The Healthcare Sector Pulling Back Or Crashing?

Additional disclosure: I am short MNKD.