Small Caps Build Steam And Biotechs Remain Well-Positioned

Summary

• Economic optimism has broadened the market rally.
• Small caps had lagged significantly and are now catching-up as they narrow the performance gap.
• The Federal Reserve driven market rally can persist till there is evidence of an uneven or slower economic recovery, perhaps in the fourth quarter.
• Biotechs and pharma appear to be well-positioned as the quest for a vaccine and a potent drug treatment continues, and when successful it can be a market accelerant.
• The stock market is overbought and can consolidate in June, but the market rally has room to extend into the third quarter.
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Market Pulse

The question of whether it's a new bull market rally or just an intermittent bear market rally doomed to end later this year will most likely be decided late in the third quarter or during the fourth quarter when enough evidence on the durability of the recovery pace is forthcoming. But whatever one's viewpoint, it is hard to ignore the present rally.

As the economic gates are being reopened, it is releasing a tide of pent-up demand that will lead to a geyser-like spurt in economic activity, boosting the economy and providing support to the stock market. There is an ongoing rotation of investor money into economically sensitive sectors and lagging segments of the market. If the economy is viewed through the lens of a post-recession recovery rather than the darker lens of an ongoing recession, then it would suggest a fuller exposure to stocks.

There is also a nagging fear that perhaps the stock market is moving too quickly in giving full credit to a rapid, V-shaped recovery. For context, the Nasdaq index has eclipsed its previous high from mid-February and recorded its new all-time high, while the S&P 500 is close to its early Feb 2020 level. As the summer matures, evidence can emerge of an uneven economic recovery. Besides, the pockets of COVID-19 infection can resurface strongly during the fourth quarter and combine with the influenza flu season to potentially create additional impediments to economic progress.

But for now, there is a gust of economic optimism that continues to sweep through the stock market.

Federal Reserve Bull Market

This gust of economic optimism has combined with the enormous Federal Government and Federal Reserve stimulus sloshing in the economy. The $2+ trillion government stimulus package will in all likelihood be accompanied by a second stimulus of over $1 trillion. At the same time, the Federal Reserve has unfolded its own Marshall Plan to support business lending and credit flow, providing a backstop to debt markets, including its $750 billion commitment to purchase corporate debt. One indicator of credit market liquidity is the spread, or the risk-premium, between high-yield speculative junk bonds and the treasury curve.

High-Yield Spread with TreasuriesSource: Federal Reserve Bank of St. Louis (click to enlarge) The higher the spread the greater the stress that exists in the credit markets. This spread has finally begun to drop consistently over the last two weeks. Junk bond issuance recorded its third-busiest month ever during May underscoring the market's ability to absorb such debt. The US corporate bond market has smashed its record of bond issuance with over $1 trillion worth of bonds issued by end of May. The Federal Reserve has averted a corporate credit crisis.

The Federal Reserve's deep intervention in what can be characterized as the biggest quantitative easing ever has laid the groundwork for both a liquidity-driven economic boost and a stock market run-up. The size of the Federal Reserve's balance sheet has soared nearly 70% or ~$3 trillion since February.

Federal Reserve Balance Sheet AssetsSource: Federal Reserve Bank of St. Louis (click to enlarge)

It is in stark contrast to the $1 trillion increase during 2009. Even though this fountain of liquidity will breed complacency towards risk and inefficient capital utilization, it is a critical support towards maintaining the economic fabric of the US and cannot be halted. The Federal Reserve is in no position this year, and perhaps much of next year, to take any support away from a fragile economy.

Lagging Small Caps Are Catching Up

The segment of the market that got most seriously affected during the pandemic-related pullback was the smaller caps. The Russell 2000 Small Cap Index dove nearly -43% at its worst point during March and at the beginning of June was still down over -16% for the year, compared to the Nasdaq's +6% gain and S&P 500's loss of -5%.

Smaller caps are highly correlated to the strength in the US economy and a transition to economic optimism creates a more favorable environment for them to improve valuations. Small caps from a broader cross-section of the economy are now joining the market rebound more vigorously. The lagging cyclical industries will continue to witness more investor attention and most likely outperform the groups that have led the market thus far, like healthcare and technology.

One approach to small-cap investing would be to attempt to mitigate the downside risk from another COVID-19 surge. This can be accomplished to some extent by considering smaller cap companies that have negotiated the first quarter relatively well or provided upbeat mid-quarter updates despite the pandemic risk. A few such companies are EverQuote (EVER), Camping World (CWH), Avaya (AVYA), Fiverr (FVRR), Celsius (CELH), Domo (DOMO), Realogy (RLGY), and Covetrus (CVET), with a few being part of our small cap model portfolio.

Biotechs and Healthcare Remain Well-Positioned

Healthcare and biotechs appear to be well-placed as discussed in a recent article. Vaccines and treatments are a prerequisite to a more normal functioning economy, and this unique ability of the biotech group anchors its placement at the forefront of the market rally. However, a group rotation into more cyclical industries can slow down the pace of gains over June.

In a late-May circular, the FDA issued its advisory on drug approval timelines indicating possible delays that can occur with PDUFA dates as the agency prioritizes COVID-19 treatments and life-saving drugs.

The New Drugs Program in CDER, and the Biologics Program in CBER are experiencing considerable increases in COVID-19 related work, requiring shifting of staff resources to help with these activities...it is possible that we will not be able to sustain our current performance level in meeting goal dates indefinitely...We intend to focus resources ...for drugs or biologics related to COVID-19 or certain other life-threatening conditions." FDA Coronavirus Update, May 27, 2020

Drug approval timelines can be delayed as the year progresses. This will not be an unexpected outcome though and should have a limited industry-wide effect, causing more short-term volatility in companies that are directly affected.

COVID-19 remains a grave threat. Even though recent social justice events have diverted attention from the pandemic, the US infection rate remains persistently high and has been zig-zagging in the range of 16,000 to 24,000 new daily infections over the last two weeks. The pandemic remains a serious and persistent threat that has not lost its edge and can gain momentum if the guard is let down, particularly as economic and social interaction rises. But the threat can be managed and diminished through greater awareness and sensible measures if Americans are diligently willing to embrace them.

A positive thing for the biopharma group and the broader market is that more news will be coming forth from trials of drugs and vaccines. AstraZeneca (AZN), Moderna (MRNA), Pfizer (PFE) with BionTech (BNTX), Merck (MRK), Johnson & Johnson (JNJ), Sinovac, Novavax (NVAX), and Innovia (INO) are a few of the players on the vaccine front. On the viral treatment side, Gilead Sciences (GILD), Regeneron Pharma (REGN), Vir Biotechnology (VIR), Takeda, and Emergent Biosolutions (EBS), are a handful of companies amongst the tens of others with new or repurposed drug treatment trials that are being planned or already underway. With so many companies attempting to find potent anti-viral treatments and vaccines, the probability of some major positive news flow during the summer months remains high.

We are presently fully invested in the Healthcare model portfolio, and the Biotech model portfolio, while 80% invested in the Smallcap portfolio. There are many healthcare and biotech stocks that remain promising. Some of these include Regeneron Pharmaceuticals (REGN), Vertex Pharmaceuticals (VRTX), Gilead Sciences (GILD), Moderna, Vir Biotechnology, Alnylam Pharmaceuticals (ALNY), Momenta Pharmaceuticals (MNTA), Acceleron Pharma (XLRN), Collegium (COLL), Halozyme Therapeutics (HALO), Iovance Biotherapeutics (IOVA), Karyopharm Therapeutics (KPTI), Immunomedics (IMMU), TG Therapeutics (TGTX), ChemoCentryx (CCXI), Incyte (INCY), Fate Therapeutics (FATE), Emergent BioSolutions (EBS), DexCom (DXCM), Quidel (QDEL), Karuna Therapeutics (KRTX), Trillium Therapeutics (TRIL), Zai Lab (ZLAB), Kodiak Sciences (KOD), BioNTech (BNTX), Kala Therapeutics (KALA), Novavax, Livongo Health (LVGO), Akebia Therapeutics (AKBA), Axonics Modulation (AXNX), Biohaven Pharma (BHVN), Vapotherm (VAPO), Arcus Biosciences (RCUS), Covetrus, Seattle Genetics (SGEN), and AstraZeneca (AZN).

Conclusion

The market has overcome the pandemic-related plunge quite rapidly. With a strong and durable recovery priced to a significant extent into market valuations, it may not take much to underperform investor expectations. This is a scenario that may present itself during the fourth quarter. But for now, the recovery phase is ascendant, and exposure to stocks is warranted.

The biggest market accelerant, besides further Federal Reserve action, will be a successful biotech outcome on vaccines and treatments.

The market due to its sharp rise finds itself in overbought territory and can likely witness a period of consolidation during June. However, the rally drivers - the Federal Reserve, the government stimulus, and the economic reopening - remain intact, and after a consolidation further gains in the third quarter are possible.

(For context this article was submitted for publication on Tuesday, June 9)

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Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s 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.

Although there are no personal positions, some stocks mentioned can most likely be already part of the portfolios of family and associates or can be bought/sold in the next 72-hours. Stocks mentioned may already be part of the various model portfolios. As always, kindly do your due diligence. The biotechs and the small-cap/early mid-cap market segments carry a higher risk of losses than the broader market. Opinions can change with time and additional data, with no obligation to update. Companies mentioned here may not be favored in the future as market trend changes and/or new information emerges, and no relevant portfolio updates will be provided unless you are a model portfolio subscriber. Graycell Advisors or Prudent Biotech or associated names and entities are not a registered investment advisor (RIA) and publishes quantitative-driven model portfolios for investors and RIAs. Some or all of the companies/stocks mentioned in the article may be in the past, now, or in the future, be part of the various model portfolios for subscribers. Past performance is not a guarantee of future results. The information here is only provided for a general informational purpose and not as a recommendation, and is not guaranteed to be complete or accurate.