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Despite the recent slide in global stock prices, it’s still hard to argue that stocks are ‘cheap’ on most historical measures. The chart below is courtesy of ‘dshort.com’ and is an average of four of their primary measures of stock market valuation. Note that the ‘short’ in ‘dshort’ does not refer to the negative practice of shorting stocks but to the founder of the website, Doug Short. The first indicator is the Crestmont Cyclical P/E10 ratio, a market valuation of historic Price-to-Earnings (P/E) ratios using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias. The second indicator is the cyclical P/E ratio, which uses the trailing 10-year earnings as the divisor. The 3rd indicator is the Q Ratio, which is the total price of the market divided by its replacement cost. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Fortunately, the government does the work of accumulating the data for the calculation. The final component is the S&P500 Index price to a regression trendline, which charts the S&P500 stretching back to 1871 based on the real (inflation-adjusted) monthly average of daily closes. This gives the data some measure relative to very long-term trend growth.
While my intent was not to turn this into a university finance session, and many could argue against the specific choice of these data sets, the bottom line is that this is a very broadly-based, long-term measure of stock valuation and it still shows that stocks in the S&P500 Index are more expensive than at almost any period of time outside of the technology ‘bubble’ in the late 1990s.
Biotech stocks crumble. We’re a little late on this story as I had the thesis for our negative view ready to go last month but ran out of room on the monthly letter. We have been very bearish on the U.S. Biotech sector and actually had a short position on the IBB (Nasdaq Biotech Index) in the JZAI Hedge Fund for the last few months (which had been somewhat painful as the sector continued to rally higher even as the rest of the market came under pressure). Biotech stocks even held up better than most of the market in the August sell-off. That all had appeared to end as the Biotech names got clobbered in the past weeks, driven in large part by the singular act of raising the price of a 62-year-old drug by more than 5,000%, to $750 a pill. That was the work of a 32-year-old former hedge fund manager who runs Turing Pharmaceuticals. After the initial uproar that ensued from the publicity about the price hike, the CEO went on network news shows to say there would be a rollback of unspecified size. But, in other interviews, he claimed the hike for the drug, Daraprim, would affect relatively few people. The events served to disprove the Gordon Gekko credo that “greed is good,” however. The utterly predictable political blowback that followed Turing’s drug-price hike knocked biotechnology stocks for a loop, with the group losing some $15 billion in stock market value on that first day alone, after Democratic presidential hopeful Hillary Clinton tweeted that she would take on such “price gouging.” That pledge by Clinton to put a stop to what she called outrageous price gouging in the specialty drug industry sent the Nasdaq Biotech Index plunging. The fear is that the sector is losing its pricing, which is a pillar of why this sector has been on fire.
Outside of overall valuation, one of the reasons for our concern over the outlook for the U.S. Biotech industry is the fact that over 70% of the profits in the group are being generated by 2 companies which have the most unsettled outlook for growth: Amgen (AMGN) and Gilead Sciences (GILD). Most of these profits are being generated by the high prices that the companies are able to charge for their products. Gilead puts the cost for their Sovaldi treatment for Hepatitis at Sovaldi costs $84,000 for a course of treatment. Add in other therapies that supplement Sovaldi, and now you’re talking about $100,000 or so to treat a single patient. To use Sovaldi to treat each of the 3 million hepatitis C patients in the United States, it would cost around $300 billion, or about the same amount we annually spend for all other drugs combined.