Getting High on Drug Stocks

As a contrarian, I've been holding a bunch of drug stocks for the past couple of years -- and it feels like they've been hanging around my neck like Jacob Marley's ghostly chains in A Christmas Carol. But lo and behold, this month they've added to my performance for the first time in years. My first reaction was disbelief -- that outperformance may be an undigested bit of beef, a blot of mustard, a crumb of cheese, a fragment of underdone potato. My second reaction was: Bah!! Humbug!! Sell.

But after some analysis... the drug stocks should continue to perform well.

First, the drug stocks staged a classic breakout from a very long base: strong price action on above average volume. Using two technical analysis measurement techniques on the Pharma Holders (PPH), I'm guessing the drug sector has another 10% move in it before hitting some resistance. And if you take the depth of the base (25 points) and add it to the break out point (80), you could see the PPH hitting 105 before you really need to worry about an overbought sector. That would also put the PPH back at the all time highs.

The valuation ratios on the drug sector, while not cheap across the board, show potential for more upside. Price to Ebitda and Price to Sales are about in the middle of the 15 year range...

Price/Book and Dividend Yield indicate that the stocks are still cheap and have a lot of overhead room to move higher.

Sentiment toward the group also remains pessimistic. Analysts have been raising their ratings for the group, but on average still rate most stocks a Hold. And a look at the put/call ratios on the PPH indicate a preponderance of puts outstanding over calls.

And finally, earnings estimates for the group have finally begun going up. Merck (MRK) has seen its 2007 estimates rise from $2.60 to $2.90, Schering Plough (SGP) has seen estimates rise from $1.00 to $1.20, and even Eli Lilly (LLY) and Abbott (ABT) have seen their estimates creep higher after a very steady decline. While not all the drug stocks have the earnings explosiveness of SGP, it seems that as a group the estimates have hit bottom and are turning higher.

So before I bury these drug stocks with a stake of holly through their heart, I'll hold on a bit longer.