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A Different Biotech Perspective

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Bailey and I (Eric Utley) often write about adopting the "institutional mentality" for its emphasis on risk management and forward-looking nature. To ignore the institutional mindset is to be a tourist, an amateur, worse yet, a piker. In that vein, let's take a look at the Biotechnology Sector ($BTK) from an institutional trader's perspective.

The $BTK ran up to the 800 level in late 1999 and again in mid-2000. The euphoria surrounding the mapping of the human genome was the primary catalyst behind the massive rally. Remember when Mr. Venter, the CEO of Celera Genomics (NYSE:CRA), appeared on the cover of Time?

Since the mapping of the human genome, the $BTK has traded effectively sideways; it's in a two-year trading range. The weekly chart reveals as much. Of special interest, note the high in late 1999 and mid-2000 up around the 800 level and the bottom around 400. Dually note the subsequent patterns of lower highs and higher lows.

($BTK - Weekly)

The recent wave of consolidation in the group, in a way, reflects the sideways trading in the $BTK. Without the necessary organic growth from new products in the last two years, larger concerns have resorted to growing earnings through acquisition.

The best example of that trend is the pending Amgen (NASDAQ:AMGN) and Immunex (NASDAQ:IMNX) merger. Amgen's primary reason for acquiring Immunex was to gain the latter's blockbuster arthritis drug, Enbrel, which is expected to generate more than $3 billion in sales by '05. In acquiring Enbrel, among other Immunex properties, Amgen hopes to boost its sales growth to the low 30s and earnings growth to the mid 20s. In comparison, Amgen grew earnings by about 15 percent annually in the last five years. So you see why Immunex was so attractive to Amgen.

The pipelines of many of the largest biotech concerns have grown unproductive in recent years. That's not to say there haven't been major breakthroughs and discoveries. There have been. On par, however, earnings growth has slowed due to the lack of new products. Sticking with Amgen -- the world's largest biotech company -- as an example, its long-term chart reveals a picture of lackluster earnings growth in the last two years. Amgen, the bellwether that it is, not by surprise has tracked the $BTK closely in the last two years.

(AMGN - Weekly)

The sideways trading is evident in the $BTK as well as shares of Amgen. But that fact is made painfully, yes painfully, clear on the $BTK's point & figure chart.

In looking for the "bigger picture" in the $BTK, I played around with different box sizes on its point & figure chart, going back to 1999. (Keep in mind that it takes 75 points for a 3-box reversal to take place on a chart using 25 point boxes.) What I found, through using a 25 point box size, is that the $BTK is four columns deep into a two-year consolidation. One more column of Xs would complete a triangle in the $BTK.

(A triangle is one of the strongest chart patterns in the point & figure methodology. Once the asset in focus breaks from its triangle, whether higher or lower, there's a very high probability that the asset will continue in that direction for a long, big move.)

The narrowing range in the $BTK on its point & figure chart again reflects the lack of conviction in the group, which is a product of the last two years in the pipeline cycle. The narrowing range does, however, portend a big move in the future.

($BTK - Point & Figure [25 pt box])

What's interesting about the narrowing range in the $BTK on its point & figure chart is how it relates to the current analyst comments concerning product development. There's been a consistent trend of upbeat comments from the sell-side of Wall Street concerning future developments among biotech companies. In my estimation, using the research from biotech analysts, the industry is about to enter the next cycle of new product development, which will drive earnings growth, in turn, taking stocks higher. Yes, the proverbial pipeline has been weak in the last two years, but that trend may change in the next nine to twelve months.

If correct, Wall Street's research gives the $BTK's narrowing trading range a bullish bias. In the meantime, institutional traders are more concerned with managing risk in the short-term and positioning for the next product development cycle. In other words, they're still trading the range.

Using the $BTK's point & figure chart (25 box size) as a guide, institutional traders are looking for a pullback into support levels for accumulation of their favorite stocks in the group, ahead of the next cycle. The $BTK is currently in a column of Os (Read: Supply) and trending lower. Given its current bearish stance, institutional traders won't be looking to buy biotech stocks on breakouts. Instead, institutional traders will continue trading the range, keeping risk at the forefront. Specifically, institutional traders will be looking for the $BTK to pullback into its bullish support trend line between 450 and 475, at which time they will begin to accumulate their favorite stocks near support levels, where risk is minimized.

If the $BTK reverses into another column of Xs, then institutional traders will adopt a more aggressive bullish stance. If the $BTK approaches the upper-end of its consolidation again, around the 600 area currently, then institutional traders will use strength to take profits, buy protective puts on their underlying positions, or perhaps sell covered calls on stocks near resistance. Again, looking to minimize risk through various hedging strategies.

When the $BTK breaks out or down from its consolidation, everything changes. The risk parameters will shift accordingly with a move out of the consolidation. A breakdown would necessitate the adoption of an aggressive bearish stance, while a breakout would necessitate the adoption of an aggressive bullish stance.

The longer-term view of the $BTK and adoption of the institutional mentality, when combined with your short-term views and market operations, will greatly aid in how to measure your risk as well as the intelligent adoption of a shorter-term, trading bias.

Eric Utley
Option Investor

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