Are Biotech Stocks Stretched? (excerpt)

On July 15, Fed Chair Janet Yellen testified before the US Senate Committee on Banking, Housing, and Urban Affairs. She presented the Fed’s semiannual Monetary Policy Report (MPR) to the Congress. In her prepared remarks, she stated that while valuation seems “stretched” in some areas of the bond market, equities “remain generally in line with historical norms.” Yet in the MPR, which bears her signature, the following observation appeared: “Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

In other words, in her opinion, the stock market is showing some signs of irrational exuberance. Of course, this term was popularized by Fed Chair Alan Greenspan in a speech on December 5, 1996 indicating his concern about a possible bubble in stock prices. About two years later, on January 28, 1999, in testimony before a Senate Committee, he defended the mania in Internet stocks by offering his Lottery Principle. The following is a reconstruction of various quotes picked up by the press from his response to a question about this issue:

“You wouldn't get hype working if there weren't something fundamentally, potentially sound under it. The issue really gets to the increasing evidence that a significant part of the distribution of goods and services in this country is going to move from conventional channels into some form of Internet system--whether it's retail goods or services or a variety of other things. The size of that potential market is so huge that you have these pie-in-the-sky type of potentials for a lot of different vehicles. And undoubtedly some of these small companies, which have stock prices going through the roof, will succeed and they very well may justify even higher prices will succeed [even if] the vast majority are almost sure to fail. There is something else going on here though, which is a fascinating thing to watch. It is, for want of a better term, a 'lottery' principle. What lottery managers have known for centuries is that you could get somebody to pay for a one-in-a-million shot, more than the value of that chance. In other words, people pay more for a claim on a very big payoff, and that's where the lotteries' profits have always come from. What that means is that when you are dealing with stocks--the possibilities of which are it's going to be valued at zero or some huge number--you get a premium in that stock price which is exactly the same sort of price-evaluation process that goes on in the lottery.”

So who is right, Yellen or Greenspan? With the benefit of hindsight, we now know that Greenspan was too much of a cheerleader during the second half of the 1990s. He certainly contributed to the stock market bubble that burst one year after he promoted his Lottery Principle. However, that principle actually makes more sense today. This is especially true for biotechnology stocks, as I wrote on July 31:

“In addition, one has to wonder whether it is even appropriate for the Fed to express opinions about specific stock groups. Lots of sophisticated investors purchase biotech companies that have no earnings and are regularly raising cash to stay in business. These investors do so knowing that the outcomes are binary: The companies they invest in will either find a cure for a disease or they won’t. Their new drugs will either be approved by the FDA or they won’t. They might be acquired for a huge premium or they might not, or might go out of business. Why should the Fed weigh in on the valuation of biotechs? After all, speculators are providing the funding that might actually cure diseases. Or they might get wiped out. Why should the Fed get in the middle?”

In any event, industry analysts have been scrambling to raise their earnings estimates for S&P 500 Biotechology industry. They now expect earnings to rise 38.7% this year and 13.6% next year compared to forecasts of 15.8% and 17.8% at the beginning of the year. Forward earnings has soared 64.3% y/y through mid-August. Consensus expected earnings growth over the next five years is around 19% per year, up from 11% in 2011. The stock index is at a record high, up 23.4% ytd and 56.5% y/y, after a brief swoon during March and April. Yet the forward P/E has actually declined from this year’s peak of 24.0 during the week of January 23 to 16.1 currently.

Within days of Yellen’s testimony, Facebook, Google, and Twitter all reported better-than-expected results for Q2 earnings. The S&P 500 Internet Software & Services stock price index is up 17.0% from this year’s low on May 8. Forward earnings rose to a new record high in mid-August. The stocks seem expensive with the forward P/E around 20. But that’s also the expected annual growth rate for earnings over the next five years.

Today's Morning Briefing: Taking Issue With Yellen. (1) Are social media and biotech stocks still “stretched?” (2) Greenspan’s clever contribution to investment strategy: irrational exuberance and the Lottery Principle. (3) The biotech lottery. (4) Binary outcomes with all or nothing payouts. (5) Is the Fed registered to give investment advice? (6) Biotech earnings expectations are soaring. (7) The Internet’s fundamentals are also hot. (8) Yellen is a two-handed economist on wages. (9) The wage stagnation myth again. (10) Are baby boomers dropping out of the labor market, or staying in too long? (More for subscribers.)