Short Selling The IBB Biotech Index ETF Into A Short-Term Correction

Jan. 07, 2020 10:07 AM ETiShares Biotechnology ETF (IBB)4 Comments2 Likes

Summary

  • Combining fundamental analysis with chart pattern recognition provides traders with essential information for identifying a market top.
  • A short-term market top has become increasingly likely as a confluence of factors indicates for this event. This presents a trading opportunity.
  • Selling and shorting market tops can be profitable. In addition, this action enables a trader to return to the long side of the market when the correction has bottomed.
  • Military tensions with Iran can be added to a list of other factors that may serve as catalysts to trigger a short-term market correction.
  • Selecting a vehicle to implement this short-selling strategy is key. The IBB biotech index ETF provides excellent volatility and is likely to trade with the overall markets.
  • Looking for more stock ideas like this one? Get them exclusively at Trader's Idea Flow. Get started today »

Chart

Data by YCharts

The iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) carries an equity beta of 1.32. This metric indicates that this security will trade with 32% greater volatility relative to the S&P 500. Traders often seek volatility as a proponent for greater trading profits. Of course, greater volatility increases the potential risk in a trade along with potential reward. The IBB seeks to track the investment results of an index composed of biotech and pharma equities listed on the Nasdaq. By shorting the ETF index we mitigate much of the potential M&A risk associated with shorting individual biotech stocks. The IBB chart below may be illustrative of a double top paired with the steep selloff that occurred at the end of 2018. Importantly, the IBB has been trading in sync with the overall market much of the time for the past two years.

ChartData by YCharts
ChartData by YCharts

As traders, we are seeking to identify a short-term top in the overall market. We believe a confluence of current factors indicates for a market correction. To implement our short sale of this market top we are seeking to introduce greater volatility into this trade. One way to accomplish this goal is to sell the IBB short. The very strong move higher in the biotech sector over recent months has given the biotech sector its longest win streak ever. This move may have caused the IBB to become short-term overextended.

We believe the IBB has begun retracing some of its 25% move higher since October 2019. Additional downside catalysts for the overall market that can help this trade are discussed later in this article.

Unsurprisingly, an overview of the IBB shows a significantly greater weighting in biotech stocks vs pharma stocks. Approximately 78% of the IBB's exposure is in biotech stocks:

The top 10 holdings in the IBB comprise about 50% of the fund's value:

We believe that the selection of the IBB as a vehicle to implement our short sale increases volatility and benefits from a possible pullback after a very strong move higher in this index. We also believe that shorting this index mitigates the risk of M&A activity that exists in any short of an individual biotech stock. For these reasons, the IBB is an attractive candidate for short sale.

A Word About Overall Market Volatility

Above we touched upon the benefits of volatility for traders as one factor leading to our selection of the IBB as a vehicle for our short sale. Here we are pointing to the volatility of the overall markets that currently exist. Volatility is a trader's friend and we believe that 2020 will be a trading range market with an upside bias. We expect the greater volatility experienced in 2018-2019 will continue into 2020. This setup for the new year paints a portrait of an optimistic opportunity for traders.

Reviewing Key Market Drivers Entering 2020

The market is now in the tail end of the so-called Santa Claus rally. This time period extends into the first week of January. After a strong 2019 that climaxed into a spectacular year-end rally, traders are now watching carefully for evidence of a market top, at least on a short-term basis. Here we discuss key fundamental drivers of the market combined with a look at several classic chart patterns that can signal a trading top in the market.

Historically, 2019 delivered one of the best S&P 500 performances in history by ending the year 28.9% higher. Yes, there's the caveat that the market began 2019 by recovering from the worst December since the Great Depression. The inference is that much of the 2019 gain was achieved by rebounding out of an oversold condition created by a steep year-end sell-off in 2018. We believe there are significant issues for investors to consider in trading the market in early 2020. The following key market drivers are points for consideration:

  • The FactSet chart below illustrates that the S&P 500 is trading at about 18x analysts forecast for 2020 earnings. The chart shows that the only time this metric was higher in late 2017/early 2018 the result was a 12% correction in the overall market to reduce valuations.

  • Markets are fundamentally driven by earnings at the end of the day. The status of this key earnings metric has likely moved into the bearish camp against the current market. As valuations of stocks increased nearly 30% in 2019, earnings growth was flat in the first half of last year. S&P 500 earnings actually fell by 2.2% on a year-over-year basis in the third quarter of 2019. It's notable that the S&P 500's three-month earnings revision ratio was flat in November and December. This indicates that the corporate earnings outlook has not improved as we begin the reporting season for the fourth quarter of 2019. We enter the year with stocks fully valued at the high end of historical norms with a price/earnings ratio of 19. Markets are trading at the high end of key metrics while earnings growth has been flat in 2019. Expectations for the approaching Q419 earnings season have been revised lower. Markets may seek to resolve the existing disparity between valuation and earnings with a move to the downside. A revaluation of markets lower could reflect more reasonable pricing of stocks relative to earnings;
  • The Relative Strength Indicator (RSI) is considered overbought at a reading of 70. The RSI now reads 75:

ChartData by YCharts

  • Window dressing by money managers was an upside catalyst into the year-end rally. Managers want to show investors a portfolio that reflects a fully invested position during a strong market. No self-respecting manager wants to face questions regarding underperformance from investors if they failed to fully participate in a year as historically strong as 2019. For this reason, managers piled into the market prior to year-end. Importantly, this upside catalyst no longer exists as the opportunity for window dressing has closed for 2019.
  • The year-end rally was accompanied by a "seller's strike" with investors refusing to take profits before 2020. By holding stocks through the end of 2019 these investors deferred payment of taxable gains into 2021. This is a sound tax strategy that affects many investor's timing for their profit taking. Obviously, this catalyst higher for markets is now absent in 2020 as investors are free to take profits without tax deferral being a factor. The seller's strike is over.
  • Momentum traders have been enjoying the series of new highs that have been taking the market to short-term overbought levels. These same momentum traders who have participated in the market's upside will be ready to take profits and sell stocks short if they perceive stalling momentum and a market top.
  • The China trade situation has been a market driver throughout 2019 on both the upside and the downside. Currently, the most optimistic expectations for a trade deal are priced into the market with little upside remaining from this market catalyst. Furthermore, our market experience tells us that reality rarely rises to the level of investor's expectations. Completion of the first phase of the China trade deal may be a good example of the "sell the news" axiom. Trade with China is very likely to remain a thorny issue with many complications for years to come. The current optimism for this situation to end well for either side may be short-lived. Details on phase one of this trade deal are murky at best and this is probably because the Chinese have been reticent to commit to anything other than buying agricultural goods, which they need to purchase anyway for their own benefit. We are not optimistic for the outcome on this important driver of the market. With investor's expectations of "China trade good news" already factored into markets to the upside, we believe that reality for the China trade deal will lead to disappointments and downside for the market in the near term.
  • Iran has been responsible for rising tensions in the Middle East in recent months. The U.S. has finally responded in an effort to prevent the killing of more Americans by Iran. Further actions against Iran may be necessary to discipline this rogue nation. These rising tensions are a possible catalyst for further downside in the markets.

Chart Pattern Recognition Combined With Fundamental Analysis

The confluence of macro and fundamental points delineated above give us the setup for a classic market top trade. We can often combine this type of fundamental analysis with chart pattern recognition to help identify a market top. We want to be on the lookout for the formation of a reversal pattern when we are seeking to identify a market top. Here are several key reversal chart patterns used to identify tops:

Summary

We believe that 2020 may be a trading range market with a slight upside bias. A single-digit percentage gain for the major indices seems reasonable in 2020 from both a historical perspective and a valuation standpoint. Valuations increased 30% for the overall market in 2019 as earnings estimates came down. A historic move higher for the market on basically flat earnings ushers us into 2020 with a fully valued market.

Trading range markets can be challenging for buy and hold investors. However, the volatility that's inherent in a trading range market can provide great opportunities for traders. Traders hoping to outperform the market in 2020 will seek to successfully execute the major trading opportunities that emerge during the year. Selling a market top as we enter 2020 would be very helpful in working toward superior performance for the new year.

A confluence of factors is indicating that we are approaching a short-term market top. Volatility has returned to markets in 2018-19 with 2020 expected to continue to be a trader-friendly market. In a fully valued market with key bearish factors aligning we are on the lookout for a signal that a market top is being made. Chart pattern recognition can be valuable in identifying a market top. Combining fundamental analysis with chart pattern recognition is a useful strategy for traders seeking maximal entry and exit points. This strategy can be used on major market indices and individual stocks, commodities, etc. Always mitigate your risk by applying risk management techniques, such as stop losses.

Conclusion

Selling (and shorting) market tops can prove to be profitable. Significantly, selling a top enables a trader to cover their short and re-enter the market on the long side after the correction has run its course. This is the definition of selling high and buying back in low, which of course is the goal of a trader. While this article is about identifying a market top, the converse of this exercise will become identifying a market bottom at a later date.

As traders, we are currently seeking to identify a near-term market top. When the anticipated near-term market top has corrected, then we will next seek to determine when this correction has run its course and put in a bottom. Again, we will apply the same process of fundamental analysis combined with pattern recognition to identify a market bottom.

This entire exercise also is known as "buying the dips and selling the rips." Sounds easy, right? Not so fast. The street is littered with broken traders who did not execute successfully. Let's take our time in considering this trade and remember that no trade at all is better than a bad trade. Risk management techniques are our best friend as we endeavor to get rich slowly and above all preserve capital. Follow us to track this advancing discussion of near-term, market trading opportunities into the future.

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This article was written by

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A former stockbroker who became licensed in 1986. Later opened a small hedge fund and managed a modest amount of assets during the 1990s tech boom. Our marketplace resource is called Trader's Idea Flow that provides actionable ideas for aggressive traders. These trading ideas are both long and short from the broader market. We also provide trading ideas / coverage on cryptocurrencies, DeFi, and blockchain technology. Please join Trader's Idea Flow in the Seeking Alpha Marketplace.


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Disclosure: I am/we are short IBB. 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.

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