Trader’s Narrative

One of the strongest sectors coming out of the February 2010 correction has been the biotechnology sector. The AMEX Biotechnology Index (BTK) tracks this sector and it has broken up from a very long term resistance level to reach all time highs. But a closer look suggests that the strength may just be a mirage.

First, let’s look at the long term chart of the Biotech index (click to see full size chart in new tab):

As you can see, the 800 resistance line goes back all the way to the 2000 stock market bubble. Biotech recovered after the 2003 bottom and like most stocks bumped its head again against resistance in 2007. But unlike most stocks, this index didn’t fall as much.

While the S&P 500 index fell by 58% (from its October 2007 highs to the March 2009 lows) the AMEX Biotechnology index (BTK) not only reached a new momentary high in August 2008, when it participated grudgingly in the 2008 bear market, it only lost 37% (from its October 2007 high).

So given this relative strength and that the recent the breakout above the 800 resistance line was extremely important because of the long term nature of this level, it isn’t surprising to see the intense momentum. It is not very visible on this long term chart but since early February 2010, the Biotech index has been white hot, basically climbing straight up!

And that’s the problem. The line below the price chart is the distance of price from its 200 day simple moving average. Right now, it is about +40% above its long term trend. I’ve marked this relative level on the chart and as you can see, price expansion leads to price contraction.

This is a rare occurrence. Whenever price runs ahead of its long term trend line so fast that it doesn’t give the 200 day moving average time to catch up, prices weaken going forward. The most recent momentum thrusts occurred in mid 2009, 2003, and of course, the huge spike in the 2000 bubble which blows all the others out of the water. There were also 3 other ones before this super-spike, as marked on the chart above.

But that isn’t the only reason to be cautious at this time. If we peer into the index itself, we find very little evidence of strength in the underlying components. Here are the components of the AMEX Biotechnology index (BTK):

According to the NYSE/AMEX website:

The BTK Index was established with a benchmark value of 200.00 on October 18, 1991. The BTK Index is rebalanced quarterly based on closing prices on the third Friday in January, April, July & October to ensure that each component stock continues to represent approximately equal weight in the index.

According to Stan Weinstein, a simple method is to look for strong sectors, like Retail and Biotech right now, and to buy the strongest components within them. So following Weinstein’s sector framework, I looked at each component. But surprisingly, I found very few that were showing a similar break out to all time highs (as the Biotech index itself suggestst). For example, Sequenom (SQNM) has gapped up but it also has a lot of overhead resistance.

Of the 20 components above, I only found few that were bullish. Here are some notes:

Millipore (MIL) is acting similar to the Biotech Index (BTK) having reached a new all time high. But that was due to a buyout by Merck (MRK). So that doesn’t really count as it basically removes it from the index.

Human Genome (HGSI) is strong reaching multi-year highs but going back to 2002 and earlier finds much higher prices and overhead resistance. The same can be said for Nektar (NKTR) but we’d only have to go back to 2006.

OSI Pharma (OSIP) has gapped up based on corporate action. Again, even with this gap up, there is ample over head resistance at higher prices.

The long term chart of Alexion Pharma (ALXN) is very similar to the Biotech Index (BTK) but unlike the index, it has yet to reach a new high. Price is acting strong but it is close to long term resistance - a $55 double top in the year 2000.

Celgene (CELG) was able to surpass its 2000 high but the most recent rally has yet to push above the double top from October 2007 and August 2008 at ~$70. Similarly, Gilead (GILD) has a fantastic chart - until 2008 when it started to tread sideways.

Life Technologies (LIFE) is probably the most bullish from a long term view - it also matches the overall profile of the AMEX Biotech Index (BTK). It hasn’t participated in the rally with the same intensity but all the longs are happy.

Celera (CRA) is probably the worst looking chart. After hitting +$240 in the 2000 bubble, price has deflated and right now it is close to its all time low.

Conclusion:
So basically, we have a sector index that has come very far, very fast with almost no real technical strength from its underlying components. To be honest, I’m puzzled by this because I’ve rarely seen this situation. Usually when an index is strong, most if not all the underlying components are also strong.

My guess is that this due to the way the index is built and rebalanced. Looking at the iShares Biotech ETF (IBB) we find a very different chart which has yet to reach new highs. For these reasons, I’m wary of the mirage of strength that is projected by the AMEX Biotech index (BTK).