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Fear Not, Biotech Stock 'Correction' Is Not a Bursting Bubble

The biotech sector has hit a slump, to put it very mildly. Large cap stocks have pulled back from above-market P/E multiples to inline if not lower than market multiples. The carnage in the small-cap space has been more significant, with many stocks falling close close to cash levels and threatening to trade at discounts. Is this the great biotech bubble bursting that many have predicted for the past year? I doubt it, but that doesn't mean the biotech sector is out of the woods even with the recent recovery on the back of healthcare M&A dea and rumors.

While some may scoff I'm playing with semantics when I argue market bubbles are different than typical market corrections (or even most bear markets), I do believe there is a qualitative and quantitative difference. When I think of a speculative bubble bursting I look back to the Nasdaq and dot-com era of the early 2000s, where the QQQ went from $120.50 in March 2000 to $19.76 in October 2002. That is roughly an 84% decline for an entire sector. If the biotech sector is a bubble bursting like that, then the iShares Nasdaq Biotechnology ETF (IBB) would be bottoming around $44 and nothing would be safe for years if not a decade plus. When the dot-com bubble burst it took all related stocks down, even profitable tech companies like Microsoft (MSFT)went from $60 to $20. To put that in perspective, Gilead Sciences (GILD) would have to drop to $28 to match that sort of decline.

While a much more severe biotech sell-off is theoretically possible, I don't believe a 2000 dot-com-esque scenario is likely to happen. That is why I have always been in the "not a biotech bubble" camp. Even so, I agree some biotech stock valuations did become stretched , as is the cyclical nature of the market. A correction was necessary. At this point, we are either at the tail end of a rough correction in the biotech bull market or the beginning of a biotech bear market. Even if this is the start of a new bear market, the lows should still be significantly higher than the bursting bubble equivalents, but this leaves open the question as to what changed in 2014 that, at the very least, put a damper on the biotech party?

Explanations are more numerous than people who invest in the biotech sector, but the simplest reason is the most likely: A deadly combination of a crowded and highly leveraged trade. Biotech has been a top-performing sector for years, and by the beginning of 2014 just about every investor -- large and small -- was chasing those returns.  What happens next? The marginal buyer disappears because everyone who wanted into the biotech sector was already invested. Also, once investors decide to exit, there are no more natural buyers for stocks.

High levels of margin debt added gasoline to the fire sale. Margin debt is going to act as a multiplier in any sell-off as it not only increases the amount to be sold but can also cause indiscriminate selling. When you combine deleveraging and an exit from a crowded trade, you get deep corrections.

I suspect the biotech correction ends like it started -- with unexpected news. Questions from members of Congress about Gilead's pricing of the hepatitis C pill Sovaldi wasn't the root cause of investors' exit from biotech stocks, but it did generate enough marginal selling to trigger a broader exodus.

Likewise, I'm looking for an unexpected positive catalyst to bring buyers from the sidelines back into the biotech sector. Whether this spark has happened already with the recent spate of M&A deals, or happens a bit later is anyone's guess. But just as sentiment could not remain extremely positive indefinitely, it will not remain extremely negative indefinitely.

Large-cap biotech stocks like Gilead, Celgene (CELG) and Biogen Idec (BIIB), with positive cash flows and attractive valuations, will stabilize first.

GILD ChartGILD data by YCharts

Investors will then move into the riskier portion of the sector, i.e. mid to small to micro caps. Don't expect the biotech sector to sharply outperform the broader market again for quite some time. When money rotates out of a high-momentum, market-leading sector, it tends not to regain leadership in the near term. This is not to say that biotech stocks are expensive or bad investments, but I would be surprised to see it as leading the broader market higher.

Sobek is long Celgene. 

David Sobek has been writing on biotech for a number of years through various outlets with a general focus on small cap oncology and antibiotics companies. He received his PhD in political science from Pennsylvnia State Univeristy in 2003 and a BA in international relations from The College of William and Mary in 1997.

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