You don't need to be a doctor or an economist to know that rising interest rates have been something of a tonic for Big Pharma. And you also don't need to be a mutual fund portfolio manager to know that the rise in drug stocks is making health care fund managers feel better.

The nearly indistinguishable one-month charts plotting the rising yield on the 10-year Treasury note and the Amex Pharmaceutical Index ( DRG) shows the tight connection between rising rates and drug stock performance. Both benchmarks bottomed out in late March, with the yield on the 10-year Treasury dropping to 3.67% on March 24, and then rocketing up to its recent range around the 4.40% level. Over the same period, the pharma index rose 4.5% vs. only 3.2% for the S&P 500.

Since diversified health care funds have their heaviest weightings in large-cap drug stocks (on average between 40% to 60%), the rise in Big Pharma also powered health care funds toward the best one-month performance of any category of domestic equity funds, rising 2.37%, according to Morningstar.

"Historically, when the Fed begins to raise rates, the pharma stocks are relative outperformers," says David Moscowitz, analyst at Friedman Billings Ramsey. (To see a contrarian view on this topic published last week, click here .)

Perhaps the best example of the historical link between rates and drug stocks took place in 1994-95 when the Fed aggressively raised overnight lending rates from 3% to 6% in about a year's time. During that period, the pharma index rose over 25% compared to a mere 2% gain for the S&P 500.

Albert Rauch, analyst at AG Edwards, says drug stocks become popular during a rising interest rate environment because they trade independently of the economic cycle. Unlike housing, auto and financial stocks, which can be whipsawed by interest rate moves by the Fed, drug stocks are far less sensitive to rate increases, partly because the industry carries a lighter debt load.

Checking Up on Health Care Funds
(Returns through 4/15/04)
Fund Ticker YTD 3 Years 5 Years Expense Ratio
Eaton Vance Worldwide Health Sciences ETHSX 4.41% 4.06% 18.14% 1.97%
Evergreen Health Care EHCYX 6.25 15.79 - 1.75
Munder Healthcare MFHYX 10.86 4.61 20.09 1.89
Fidelity Select Health Care FSPHX 6.03 - - 0.99
State Street Research Health Sciences SHSSX 8.64 18.48 - 1.25
T. Rowe Price Health Sciences PRHSX 10.03 10.06 11.96 1.00
Vanguard Health Care VGHCX 3.93 7.47 13.03 0.28
Amex Pharmaceutical Index ^DRG -2.4 -13.9 -16.5 -
S&P 500 SPX 1.95 -0.07 -1.76 -
Source: Morningstar

"People buy drugs whether you are in a boom or a bust," says Rauch. So, sales are more consistent and operating costs more predictable.

That's not to say that drug companies exist in a vacuum. In fact, Big Pharma is heavily tethered to Washington, even if it's not the Federal Reserve's monetary policy. Congressional battles over Medicare drug benefits, as well as the fight over legalization of drug re-imports from Canada have long weighed down drug stocks and the health care funds that hold them.

"Every two years there is an election in this country that spills venom on Big Pharma," says Morningstar analyst Christopher Davis, describing something of a cyclical problem for what is generally considered to be a noncyclical sector. What's more, presidential election years -- with the 2004 one already a good example -- put even more focus on health care costs and industry profit margins.

Davis is also unsure whether the classification of drug stocks as a "defensive" group (along with food and tobacco) is still valid considering the sector's poor performance in the recent bear market. According to Morningstar, in 2001, the average health care fund was down 11.5% compared to the S&P 500's 11.8% loss. In 2002, the average health care fund and the S&P 500 were down 27.8% and 22.1%, respectively.

Conversely, in the recovery year of 2003, health care funds showed their "offensive" abilities by outperforming the S&P 500 index by 3.3%, although some big-name drug players -- Merck ( MRK) for one -- underperformed the market.

Robert Hazlett, analyst at SunTrust Robinson Humphrey, acknowledges the historical link between interest rates and drug stocks, but says "the sector has the ability to outperform in any interest rate environment because of the demographic challenges facing America, which will lead to the increased use of medicine." The huge Baby Boom generation is approaching retirement and life expectancy rates are on the rise.

It's those exact "demographic challenges" that have investors betting on the graying of America in huge numbers. The Vanguard Health Care fund ( VGHCX), for example, is the largest sector fund in existence, with $21 billion in assets.

The Vanguard fund is also one of Morningstar's top three health care fund recommendations, the other two being Fidelity's Select Health Care fund ( FSPHX) and the $1.1 billion T. Rowe Price Health Sciences fund ( PRHSX). (See chart.)

The spotlight will narrow from the entire sector to individual performances this week as five of the largest members of the 15-stock pharmaceutical index report earnings this week: Eli Lilly ( LLY) (April 19), Pfizer ( PFE) (April 20), Wyeth ( WYE) (April 21), Schering Plough ( SGP) (April 22) and Merck (April 22).

Particular attention will be paid to Pfizer's first-quarter results on Tuesday morning because analysts like AG Edwards' Rauch often refer to the company as a de facto index for the sector due to its enormous size. Pfizer's stock, for example, accounts for more than 7% -- or $1.47 billion in value -- of Vanguard's Health Care fund and 6.92% of the Fidelity Select Health Care fund. The Thomson First Call estimate is for the company to earn $0.51 cents a share vs. $0.45 a year ago.

Despite being up 6.3% year to date, Pfizer shares have been essentially flat over the past two years. On a relative basis, however, the stock has substantially outperformed the pharma index, which is down 10% over the same period.

And in case you historians were wondering, during that 1994-95 period when the Fed was putting the screws to the federal funds rate, Pfizer stock rose about 30%.

After the earnings come and go, however, analysts like Moscowitz (of Friedman Billings Ramsey) expect rising interest rates to once again start driving investors out of tech and other interest rate-sensitive stocks into health care funds. That happened in February, when the Nasdaq's big 2004 rally abruptly ended, and also last summer when the market rally appeared ready for a consolidation or correction before surprising many analysts with another sharp move up through the end of the year.

"Aside from interest rates, you have some big-name tech companies that have missed earnings expectations, so there is a lot of cash out there looking for a place to go, "says Moscowitz.

What remains to be seen is whether individual drug companies will be able to meet expectations going forward in the face of political and competitive pressure. Interest rates help, but a deep pipeline of new drugs is more powerful than the Fed's medicine.