A Wild Week In Biotech
The FOMC targets speculators, biotech catches collateral damage
It's been a particularly wild week in biotech, mirroring the insanity we saw in the overall market. On Monday, breadth in the NASDAQ Biotech Index (NBI) was 19-143, one of the two or three worst breadth days in the last 16 months. On Thursday, breadth was 177-17, one of the best four or five breadth days in the last three years.
The takeaway? Biotech can be volatile, but I hope you knew that before you took the position.
I think the rally probably has some legs, but I think they're short legs. I also think an explosive move off these lows (like April/May 2005 or August 2004) is unlikely. I just don't see people putting down a ton of cash into biotech at this point on the calendar. I've asked many biotech funds guys "what's up" over the last couple of weeks and everyone says "everyone else" is selling for the summer and will be back in August or September. They, of course, are long-term investors so they aren't the people who are selling.
So what do you do with this? It really depends on your style. If you're fast money, you really have little choice to but to play along. There are actually a fair number of summer binary events, at least in the group of dev-stage biotech stocks we're familiar with. If you're medium term (9-15 months) then you could really find some bargains over the next few months – particularly if Chairman Bernanke continues to channel Dr. Greenspan from late 2000 (more on this in a moment). If you're long term, let out a big "whoopee" and smile as you take advantage of short-termers to acquire more shares – just don't do it all at once as I expect there'll be some additional opportunities between now and mid-October.
The other side of that qualified bearishness has some decent firepower:
Minyan Jeff Saut and Professor Jason Goepfort both pointed out earlier in the week they thought we were at a tradable bottom. Hays Advisory Service pounded the table for the bullish side. I could go on for a while with a list of smart folks who think we rally from here, even if I don't count folks who are normally biased towards the bull side.
The corporate bond market continues to provide cash for buyouts and buybacks to companies at a record clip. This is the most important difference from the experience of 2000.
Biotech buyouts are still a factor, and are likely to heat up at the headline level. ImClone (IMCL), assuming it has found interested buyers during its search, shouldn't take too much longer to sell itself. Yesterday's story on Millennium (MLNM) isn't likely to go away now that larger companies know it is on the block.
FASB should decide in the next 2-3 months their deadline for the new acquisition accounting rules, supplying a calendar deadline for pharma acquisitions of biotech. We're hoping for 12 months from now, but realistically expect it to be 12/2007.
Here's why I'm having trouble getting too excited about this rally, even though we're participating in the buying. (The following is part of a note we sent to our clients on Tuesday, outlining strategies for people who wanted to participate in a likely bounce.):
In 1999, FOMC Chairman Alan Greenspan declared that equity markets would need to be a focus of FOMC policy. Since that time it has become apparent the equity markets have become more than a focus, they've become a tool for FOMC broader economic policy.
We believe the first time the FOMC tried to use this tool as a primary vehicle for modifying the economy was in 2000 -- specifically towards the end of 2000 and early 2001 where "unexpected" rate hikes by the FOMC put the nail in the coffin of many hedge funds who had hung on by the skin of their teeth. The hoped-for year-end 2000 rally didn't materialize due to the rate hikes. The resulting gutting of speculators was the end goal of the FOMC.
We're not going to engage in another tirade about how the FOMC needs to get the heck out of the way of the stock market. Their use of the markets as a tool for FOMC monetary and economic policy is fact. Our problem is we don't know what to expect from the usage of this tool because it is brand new and the only other time they used it to slow economic growth was complicated towards the end of their cycle.
The FOMC's initial experiment in using the market as a tool lasted, in our view, about a year. From the fall of 2000 to the middle of 2001, there were no good economic reasons to keep pressuring the markets. The bubble-influenced economic boost had been gutted and employment rates were falling like a rock. However, there were embers of speculation still present at the end of 2000 to where a stop to the then largely symbolic rate hikes would have resulted in a relatively quick restart to the go-go activity we saw in late 1999 and early 2000.
By August 2001, a limited number of market prognosticators believed the market was turning. By early September, an even smaller number were willing to say those views aloud. Then we had September 11 and all the best-laid plans were made moot.
We are not of the view that the modern FOMC is stupid and unable to learn from their mistakes. While a new FOMC head might be caught up in the chase and forget the bigger picture, we're relatively confident there is enough institutional memory in the staff and the rest of the FOMC to retain the central lesson of that experiment.
The lesson of the first equity market experiment is external shocks can cause serious problems -- serious enough to where rational people are less willing to risk overshooting your target level of economic activity to the downside. When the 9/11 event happened, the FOMC had to pull out every stop it had over a period of nearly three years to get the economy back to levels it found comfortable. We believe that period was very uncomfortable to the FOMC and is something they really don't want to repeat.
While it is not reasonable to assume the FOMC is expecting another 9/11, they are going to be cognizant of the effect on the market of issues in Iran, North Korea, and/or Taiwan/China. Once the FOMC has the market's attention, we expect they'll be content to sit back and watch -- especially after so many consecutive raises of the Fed Funds Rate.
I was on the phone with a client yesterday and asked him if he ever had music lessons or was familiar with a metronome. A metronome is a gizmo that swings back and forth, clicking at the apex of the swing to help musicians keep a steady tempo. It's a pendulum, and an apt visual metaphor for what I think the FOMC is up to.
If you lengthen the metronome, the swings on either side are longer and you spend more time away from the middle. Things "click" less often. If you shorten the metronome, the swings on either side are shorter and you "click" more often.
I think the FOMC's take away from the 2001experiement with the markets as an economic policy tool is to shorten the metronome. Be more aggressive early, use a tighter range, and see the economy "click" into their targets more often.
Did this drop wring enough speculation out for Dr. Bernanke's tastes? I rather doubt it, but ask me in a couple of weeks after we see how metals, commodities, and energy perform. Slapping speculators out of those markets – particularly the energy markets – is the best way for the FOMC to control inflation since price rises there long ago passed any semblance of connection to reality.
We're certainly going to get one more rate hike. While I personally think that's all that is necessary, the FOMC might disagree. We'll know by how hawkish the talk is after the next rate hike. (FWIW, I would expect a hawkish statement to accompany the next rate hike.) If we see a rerun of the inflation hawk verbal assault we saw over the last week or so, I'm guessing we're in for more because the FOMC has decided to wring more speculation out of the market.
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