Last week, following the sector specific comments of the Federal Reserve Board, I suggested that ultimately the market would ignore them. In fact, I would go even further; as I pointed out then, Alan Greenspan’s famous “irrational exuberance” comment was made in 1996, just before the real explosion in stocks began. It is unlikely that exactly the same will happen again as investors are a little wiser for that experience, but the recent price drops in those sectors will most likely prove to be only temporary.
There is some inevitability about this. At first glance it seems as if a warning such as this is telling us to stay away from, in this case, “smaller firms in the social media and biotechnology industries.” In reality there is little or nothing that the Fed can do about it. They have identified a booming area and the temporary halt to that boom that follows them voicing their concern just constitutes a needed correction, after which the upward march can continue.
That doesn’t mean that the two targeted sectors will rebound equally. Social media valuations do seem to have more potential problems. Because Facebook (FB) has solved the problem of monetizing popularity in the space the assumption is that the smaller upcoming firms will be able to do the same thing. The struggles of Twitter (TWTR), however, who have still never actually made a profit, should serve as a warning. In biotech the revenue and profit implications of successful trials are often huge. Admittedly some of the drugs that constitute these companies pipelines will fail trials and never see the light of day, but that is a known risk that is easily countered by diversification.
That diversification is readily available. The SPDR S&P Biotech ETF (XBI) holds 98 different stocks, with no one company making up more than 2 percent of the total. The fund has a reasonable expense ratio of 0.35 percent and provides a decent base for those who want exposure to the space with risk at least somewhat spread.
SPDR S&P Biotech ETF XBI
As you can see, XBI reversed last week’s “post-fed” fall on Friday but still has around 12 percent room to the upside before the previous high is reached. If I am right and the breather just sets up another surge, then the $170.66 high from late February is more likely to provide the next real resistance level, representing a short term upside of over 20 percent.
If you are comfortable with even more risk than simply investing in biotech entails then there is no shortage of individual companies whose stock price has been hit hard following the Fed’s observation that the sector was doing well. This can be particularly pronounced when a stock was already falling, such as in the case of Arrowhead Research (ARWR).
Arrowhead is typical of biotech stocks in many ways. They have never made any money and have a varied pipeline, but hope rests with one drug in particular. In this case it is an RNAi treatment for Hepatitis B. ARC-520, the drug in question is still only in early Stage 2 trials, so monetization is a long way away, but has multi-billion dollar potential if efficacy is proven.
Arrowhead Research (ARWR)
The stock has collapsed from March highs of over $26, but it is hard to find a reason why beyond the basic revaluation of speculative momentum stocks. It seems there may be rumors that the company’s deal with Alnylam Pharmaceuticals didn’t give them complete control of the intellectual property surrounding ARC-520, but these were put to bed by Arrowhead's recent press release. Of course, it could be that I am missing something vital here; if so, please feel free to enlighten us in the comments section.
There is obviously significant risk in buying a stock that has dropped 58.2 percent in just over four months, so you may prefer the more conservative route of buying XBI. I would probably favor a combination of the two, but however you play it, history tells us that the biotech sector is about to rebound. It is not that I do not respect the views of the Federal Reserve; of course I do, but essentially, as in the past, all they have done by being specific about sectors is point out where the biggest potential upside is.