Biotech 'Bubble-Watch' in Overdrive

Key technical levels to watch on the iShares Nasdaq Biotechnology ETF (IBB) as 'bubble' talk heats up

Editor-in-Chief
Jul 6, 2015 at 11:44 AM
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The following is a reprint of the market commentary from the July 2015 edition of The Option Advisor, published on June 25. For more information or to subscribe to The Option Advisor, click here.

"Bubble-spotting" has become a favorite pastime on Wall Street, with fund managers, analysts, journalists, and even the Federal Reserve racing to point out the next unsustainable asset surge. In fact, it was just last summer that the Fed made headlines by citing "substantially stretched" valuations for social media and biotech stocks in its biannual report.

The Fed -- and namely, Chair Janet Yellen -- took plenty of heat for weighing in on equity valuations, with many armchair critics calling for the central bank to stay in its lane, and quite a few market-watchers on Finance Twitter making snarky references to the latest "research note" from "Yellen Macroprudential," or citing the latest returns for the "Double Inverse Yellen Fund."

However, less than a year later, it seems the Fed's warning of a potential biotech bubble has become the accepted consensus opinion. A Google News search for "biotech bubble 2015" yields just shy of 48,000 results -- and the results aren't limited to financial news outlets, with mainstream publications such as TIME, The Globe and Mail, and even Gawker jumping on the trend.

Just this week, in fact, The Wall Street Journal pointed to the launch of two new, triple-leveraged exchange-traded funds (ETFs) on the sector as "fuel for the biotech-stock frenzy," and warned that investors may get "burned." (We will not argue with the thesis that one should proceed with extreme caution when considering leveraged ETF products, though this particular development may be more indicative of a looming bubble in the "specialized ETF" space, rather than in biotech itself.)

Meanwhile, Bloomberg reported that "demand for options tied to declines in an exchange-traded fund tracking [biotech] companies rose to the highest level in three years relative to bullish ones." The article also cites an unusually high skew for biotech options -- meaning puts are markedly more expensive to buy than calls -- along with a relatively high level of short interest levied against the sector. One analyst is quoted as saying that biotech has "the most bubble-like characteristics" of any area of the market.

All of which begs the question: If everyone agrees there's a "bubble" in danger of popping, aren't we missing one of the key contrarian ingredients (euphoria) necessary for the formation of a top? But before we get too far ahead of ourselves, let's defer to the most crucial indicator -- the price action.

From 2004 to 2006, the iShares Nasdaq Biotechnology ETF (IBB) traded sideways between $70 and $85. It wasn't until 2011 that IBB finally broke out above decisively above this sideways channel. Since then, multiples of the $85 level have been significant for the ETF. Specifically, $170 and $255 have acted as speed bumps in recent years, while the $340 level gave IBB only a moment's pause before emerging as support, with this price point defining the lower boundary of a recent range. By this logic, $425 would be the next likely resistance area, representing upside of about 13% from IBB's closing price of $375.84 on June 25.

Additionally, IBB recently took out the $360 area, which coincides with a 20% year-to-date return, and which had acted as resistance since mid-March. Closer at hand, another key level worth noting is $375, as this area will represent a 50% year-over-year gain until early August (as the IBB essentially flat-lined from this time until early August last year). Sometimes, these 50% year-over-year levels will act as speed bumps, though the fund has spent the past week or so solidifying a foothold above this area.

And our internal sentiment data confirms Bloomberg's reporting by revealing a hefty dose of skepticism levied against this outperforming sector. We track 69 stocks under the "Biomedics/Genetics" umbrella, and 78% of those are currently trading above their 80-day moving averages, with an average 52-week return of 52.8%. And over this same 52-week time frame, short interest on these stocks has jumped by 11.8%. The average short interest-to-float ratio of the group is a hefty 17.2%, which translates to a short interest ratio of 10.1 days to cover -- a rather healthy supply of sideline cash.

Likewise, Schaeffer's put/call open interest ratio (SOIR) for IBB arrives at 2.53, with puts more than doubling calls among options set to expire within three months. This SOIR outranks 83% of other such readings from the last year, indicating a stronger-than-usual skew toward puts over calls among speculative players.

Against this backdrop, a hesitation or mild pullback by IBB to its 80-day moving average would mark a potential buying opportunity, according to our quantified data. Since 2009, IBB has met up with this trendline on 20 occasions. Looking out 63 days after these signals -- roughly three months' worth of trading -- IBB has been positive 84% of the time, sporting an average gain of 10.3%, and a median return of 9.3%. (The most recent signal, in late April, has not yet closed, but early returns look good almost two months in.) As of this writing, IBB's 80-day moving average was docked at $356.36 -- which, it should be noted, means a retreat to this level would put some of the aforementioned levels of possible resistance back into play.

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While the onslaught of doomsday headlines, high levels of short interest, and recently bearish option activity seem to suggest that the biotech rally has not yet reached the euphoric heights traditionally associated with bubbles, we would be remiss not to acknowledge the possibility of volatile price action for IBB. Biotech companies are notorious for having somewhat lopsided or speculative product pipelines, which means unfavorable FDA rulings or the emergence of a competitive drug can spark drastic sell-offs. But that's why call options are an ideal vehicle for this kind of trade -- they require less upfront capital commitment than buying shares outright, and the potential loss is clearly defined and capped by the premium paid.

All of that said, eager bubble-spotters may wish to turn their gaze to China. A recent New Yorker piece noted that, while the fundamentals of the Chinese economy have been slowing, the stock market has been pushed higher by "a flood of new money, much of it from inexperienced investors." Even more troubling, a rally in Shanghai was sparked earlier this week by bullish headlines from state-run media outlets. With investors eagerly biting on upbeat propaganda -- even as the Deutsche X-Trackers Harvest CSI 300 China A-Shares ETF (ASHR) breaks down below short-term support -- it looks as though the next bubble to burst may be in Beijing.


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