Biotech Is Setting Up for Another 1,347% Rally

"This nasty man-made microbe, hatched in the labs of Wall Street, surfaces every few years to prey on susceptible (i.e., gullible) investors. Symptoms include feverish optimism followed by cold chills of reality." – Time Magazine, 1997

 

Spectacular booms and busts are the norm for biotech stocks...

 

Whenever a breakthrough in cloning, genetic engineering, or stem-cell treatments bubbles up out of a lab and finds itself on the front page of a newspaper, investors go temporarily insane.

 

They put on their blinders and imagine the life-altering, society-changing possibilities that will (eventually, maybe) emerge from the latest breakthrough. They set to work building their imaginary castles in the sky.

 

Then a year or two passes and the shine wears off the breakthrough. This is when investors realize the technology is still in its infancy, and profits probably won't emerge for years. The dream goes stale, and the bubble bursts.

 

Since 1983, biotech stocks have exploded higher in four triple-digit rallies and one quadruple-digit rally.The sector has also routinely plummeted. Since 1983, the biotech sector has lost more than half its value four times.

 

The following chart shows the performance of the Datastream Biotech Index since 1983.

 

The Booms & Busts of the Biotech Industry 

 

 

As you can see, roughly every 18 months to three years, biotech companies undergo an expansion or contraction. These cyclical moves can be quite dramatic. For example, over the last five expansions, the smallest biotech rally produced a return of 187%.

 

Here's a rundown:

 

Average Expansion Length	2.6 years
Average Expansion Gain	+565.5%
Average Contraction Length	1.9 years
Average Contraction Loss	-46.1%

 

The biotech industry is currently in the midst of a contraction, down 13.4% since the end of November 2005. That means it's been in a downtrend an above-average 2.3 years. However, its 13.4% fall is unusually modest.

 

In other words, the biotech sector is stuck in the doldrums. But keep your eyes open... When this sector takes off, the returns can be spectacular.

 

Here's what I look for to signal a breakout: higher highs, higher lows, and an overall percentage gain that is larger than the typical bear-market correction. Given the modest volatility of biotech stocks during their latest slump, I would look for a minimum percentage gain of around 20% before considering taking a position.

 

When the biotech bug returns, you should consider buying one of the biotech ETFs, like the SPDR S&P Biotech ETF (XBI) or a large, relatively safe biotech company like Amgen (AMGN) or Genentech (DNA).

 

Good investing,

 

Ian Davis

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