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Biotech: Boom or Bust?

Updated: Nov 11, 2022

Biotech has been a hot sector since July, when the XBI ETF reversed and began its impressive breakout. The question many have now is whether the next move in this industry's stocks going to be a boom or a bust. Ayesha and I take a look at the ETF in this article that we've co-authored and share a trade idea based off of our collaborative research.

An Optimistic Take

The biotech bull thesis is driven primarily by M&A activity in the sector, but there are only a few big buyers out there who have the financial strength to make acquisitions. With capital costs increasing, companies will be more cautious about allocating capital and we’re already seeing this across the board.

Some also suggest that the sector is primed for a further run after such a significant sell-off, which as of the writing of this article is still down over 50% from its all-time high. However, we’ve also seen a greater than 50% gain off of the lows in May-June, and at this point a rejection from overhead supply.

Acquisitions in the space are more likely to take place for companies that have assets and a solid offering (think One Medical being bought by Amazon) or companies that have verified patents (think Global Blood Therapeutics being bought by Pfizer).

Many of these larger companies also benefited from the bull run over the past two years and are now putting that cash to good use. But, with a recessionary environment approaching, the question to ask is how many will continue to invest. These acquisitions were also strategic moves in an attempt to pivot – Amazon was trying to upgrade their now defunct Amazon Cares Network and Pfizer focusing more on research and development.

The Vial Half Empty View

The bear thesis is that long duration risk assets are negatively correlated with rates, and with rates rising, an increased cost of capital is harmful to companies that do not make money and have a fair amount of debt obligations both present and future.

JNK and XBI are trading as if joined by the hip, and high yield debt is objectively overpriced by quite a lot

Success rates are falling for biotechs, currently at 7.9% for likelihood of approval from phase 1; phase 2 is just 28.9%. This means that the vast majority of biotechs are likely to have failed product pipelines. This eye-opening statistic strongly suggests that many of these companies are not destined for success. This is a very hit or miss industry.

A large portion of the rally in Biotech’s were driven by the excess liquidity in the system but, as well in part by the “hope” factor. As we saw companies like Moderna take off for engineering a “vaccine” for Covid, it fueled the optimism in people that biotechnology was the next big thing. Some of that was also driven by funds like Ark Invest heavily backing companies that had not even passed the first phase of trials.

As with other tech companies, IPOs were huge successes simply because we were in a raging bull market. Most of the people who even invested in these biotech IPOs didn’t have faintest clue as to what they did. The technology and the biology were both complicated, and yet people piled into them simply because they were cheap and “hot” stocks.

While this biotech rally was occurring, one driving component was also options flows in to the 3X leveraged LABU biotech ETF, where there were multiple days that qualified as ‘delta squeezes,’ whereas there were instances that volume exceeded open interest on close to the money, near dated calls in the ETF.

This created more demand for units, helping to push price upward for both LABU and XBI. Similarly, some of the key XBI components saw delta squeezes since the June bottom as well.

The Trade Setup

  • Closure below $85 on a daily basis initiates the first leg of the short trade. Closure below $80.55 initiates the second leg of the short trade. Finally, closure below $78.25 initiates the final leg of the short trade.

  • Stopping out would happen if there is a close above the daily EMA(8) or an upward move of over 3.1%.

  • Downside cover targets are as follows: 1) $69.03; and 2) $63.53.

  • The time period for this trade is three months. If the thesis doesn't play out in that time period we would exit the trade.

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