For months, the experts have been duking it out about whether or not the biotech sector is in a full-blown bubble. In one corner, we have the Richard Bernsteins of the world. Even though the iShares Nasdaq Biotechnology Fund (NASDAQ:IBB) essentially doubled in price over the last two years, they're dismissive. "Bubbles pervade society," says Bernstein. "They are bigger than the financial markets. I don't think the biotech speculation is that broad… So, no bubble, in my opinion."
In the other corner, we have those like Reformed Brokers Josh Brown, who believes that the bubble is plain as day. "Anyone with a protein compound under a microscope and a clean suit can go public right now," says Brown.
Now, I admit that the data backs Brown up. An uncharacteristically high number of biotech companies (37) went public last year. Yet the pace isn't letting up one bit. By March 20, another 24 biotech companies have gone public in 2014.
So is there more pain in store for biotech stocks? And, more importantly, does it really matter to investors who aren't invested in the sector? Let's discuss.
A Risky Proposition
Let's be honest about one thing: If any sector in the market is pre-disposed to overheating, it's biotech. After all, an investment in any biotech stock is a speculation on the future sales of an unproven drug. So by nature, every bet you place in the sector is extremely hit or miss.
Yet, true to form, we're prone to focus on the potential upside more than the downside risk. Especially since analysts tend to be exceedingly optimistic, too…
Case in point: After analyzing over 1,700 analyst forecasts, Morgan Stanley's (NYSE:MS) Matthew Harrison and Dr. David Friedman found that consensus drug sales estimates were completely inaccurate.
"Most consensus forecasts were wrong, often substantially. And although consensus forecasts improved over time as more information became available, accuracy remained an issue several years post-launch."
And when the researchers say "substantial," they mean substantial. "A significant number (53) of consensus forecasts were overly optimistic by more than 160% of the actual peak revenue of the product." If nothing else, let this be a reminder to all of us to 1) take any expectations we have about a biotech's potential and 2) slash it in half - immediately.
Getting back to the matter of a biotech bubble, average valuations certainly appear frothy. The IBB fund trades at a price-to-earnings ratio of 44.1 and a price-to-book ratio of 11.23, which compares to 18.0 and 2.6 for the S&P 500 Index, respectively. So there certainly could be more bloodletting ahead. But only time will tell whether or not the 15% pullback for the sector since February 25 represents the beginning of the end, or just another breather before the next upward charge.
My take? If you're sitting on profits in the sector, protect them with trailing stops. It's better to be safe than sorry.
Don't Sweat the Little Stuff
If you're not invested in any biotech stocks, it's only natural to still be concerned that a nasty downturn in the sector could end up sinking the entire stock market. Fight your instincts! It's not a legitimate concern. Although investments in biotech stocks might represent a good measuring stick for investors' appetite for speculation, the sector's significance in the big picture is minimal at best.
Or, as Howard Silverblatt of S&P Dow Jones Indices notes, the market cap of the S&P biotech industry is only equal to about 2.4% of the entire market cap of the S&P 500. Granted, that's swelled noticeably from the 0.4% level during the height of the 1999/2000 bubble. But it's still too small to matter much.
Put simply, even if the biotech sector disappeared completely, 97.6% of the S&P 500 would remain intact. And the overall impact on performance would be minimal.
Bottom line: We can't be certain whether or not the impressive bull run for biotech stocks is officially over. One thing we can be certain about, though, is that no matter what happens next with biotech stocks, it won't unduly impact the broad market.
Disclosure: No positions.