After a multi-year rally, the biotech sector saw a sharp correction. The correction began in the middle of 2015 and worsened at the start of this year. In the past one month though, the sector showed signs of recovery. But with the iShares NASDAQ Biotechnology Index ETF (NASDAQ:IBB) seeing a sharp pullback in the last three days, the question is whether the short rally is now over.
Biotech Sector Correction
The five-year chart below for the IBB shows that the multi-year rally ended in July 2015.
From Google Finance
Ahead of the correction, there had been questions about the high valuations in the biotech sector. A pullback therefore was not such a bad thing. However, the sell-off worsened in the sector in September 2015 when Democratic Presidential candidate Hillary Clinton tweeted about price gouging in the biotech sector. The price gouging issue mainly centers around "platform companies" such as Valeant Pharmaceuticals International (NYSE:VRX). VRX itself has lost more than 90% of its market value since its peak in 2015.
In late 2015, the biotech sector did stage a strong comeback and in fact ended the year on a very strong note. However, the start of 2016 saw a huge sell-off in global equity markets and the biotech sector was one of the worst performers. In the first quarter, the IBB dropped more than 23%. But over the last one month, the sector has staged a comeback. As the one-month price chart for the IBB shows, the sector staged a comeback in late March.
From Google Finance
A Strong Rebound or A Short Relief Rally
This week, the biotech sector had seen a sharp pullback. In fact, IBB breached a key technical level as the chart below shows. The ETF dropped below $280 and is now moving towards another key support level at $270.
The short-term sentiment could change though as we have a spate of biotech earnings in the next few days. Any positive surprises could give a temporary boost to IBB. However, the question remains whether the sector is fundamentally strong to regain the mid-July levels.
More Downside Risk Than Upside Potential
I see more downside risk in the biotech sector than upside potential. And this assessment is based mainly on fundamental factors.
The first major issue is that this is an election year. While political rhetoric over the drug pricing issue seems to have quieted lately, the sector remains vulnerable to attacks. At the time of writing this article, the Senate was holding a hearing on drug pricing. According to an article published this week on Politico, drug companies are likely to spend $100 million in an effort to squash a referendum in California on price control. It is quite clear that drug makers see the pricing issue as a major threat in an election year. I expect this to keep sentiment on the sector negative.
Then there is valuation. IBB is down more than 18% this year but when you look at the 5-year chart, it can be seen that the sector is still richly valued. When the sell-off in the biotech sector intensified at the start of this year, several analysts said that this might lead to a pickup in M&A activity in the biotech sector. However, we have not seen a deal frenzy so far. Several big biotech companies certainly have the resources to complete deals. But they have remained on the sidelines, which indicates that the sector is still overvalued.
Things have also been quiet on the IPO market front. In fact, we have seen some IPOs being withdrawn. In the past couple of weeks alone, we saw at least three biotech companies withdraw their IPOs. Obviously, companies themselves feel that the sentiment is still negative on the sector.
Finally, there is the regulatory factor. Last year, we saw a record number of drugs being approved by the FDA. This has given biotech bulls a false sense of security. What bulls have forgotten because of this is that getting a drug through to commercial stage is a long and cumbersome process and only a small percentage of companies actually succeed. A few setbacks on the regulatory front this year have put things into perspective. Even this week, in one of the most talked about FDA panel meeting to discuss a New Drug Application (NDA), the vote was negative. There was tremendous pressure on the panel members to vote in favor of an approval for Sarepta Therapeutics' (NASDAQ:SRPT) DMD drug eteplirsen. The panel voted against an approval although I must add that the vote was not unanimous.
Based on these fundamental factors, I believe that the short relief rally may be coming to an end and the correction could resume.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.