The SPDR S&P Biotech ETF (NASDAQ:XBI) shows a cumulative drop of approximately 50% in the last year. It is the largest cumulative drop in its history.
There are several reasons for this debacle:
- Correction of one of the largest accumulated increases in the index: From March 2020 to February 2021, the accumulated increase has been approximately 150%. The rise reached irrational limits in late 2020 and early 2021 when virtually every stock in the biotech sector rose day after day for no compelling reason.
- Reaction to the foreseeable rise in rates by the Fed in a scenario of high inflation.
These two are the main reasons, in my opinion, that have caused the collapse of the XBI index. Surely there will be more reasons, but the ones that carry the most weight, in my opinion, are the two that I have named above.
As for the first cause, at current levels (around 90 points), it can be said that all the accumulated rise in the last year and a half has vanished, so this cause no longer makes sense.
And as for the second reason, interest rate hikes, it is true that the Fed seems ready to start raising interest rates shortly.
This rise in interest rates will imply that the yields of lower-risk assets, that is public debt securities, will increase. Therefore, riskier assets will lose some of their attractiveness to investors. This is a basic principle in economics.
But the important thing here, in my opinion, is to know if we are facing a scenario of long-term rate hikes, or on the contrary, we are facing a scenario of specific increases in short-term interest rates.
The variation of interest rates is the main monetary policy instrument available to the monetary authorities. Faced with inflationary scenarios and strong economic growth, a restrictive monetary policy is applied, that is, rate hikes to cool down the economy and reduce inflation. On another hand, with declining scenarios, expansionary monetary policies are applied, that is, lower interest rates.
In the current case, with a sharp rise in inflation (it seems that inflation is going to reach 7% this year), the Fed has reacted by announcing its intention to raise rates.
The abrupt rise in inflation has been caused by the aggressive rise in the price of raw materials, especially gas and electricity, and by the supply problems derived from the confinement after the pandemic.
However, this sharp rise in inflation is not a reflection of the economy overheating. In fact, in 2021, US GDP is expected to have grown by just over 5%. And for this year 2022, growth of more than 3% is expected. These are good growth figures, but not enough to be considered excessive growth.
Therefore, the Fed will probably only initiate a temporary rate hike to deal with inflation. I don’t think it will be a long-term sustained rate hike, but a small temporary rate hike.
Inflation will stop growing at these high rates sooner or later, and the Fed will stop raising rates and might even lower them again if growth is threatened.
The XBI index has already priced in the likely rate hike, and I really don’t think it will go much lower than current levels (89). I think it has already bottomed out and I expect a slow recovery will begin soon. I don’t think XBI will recover quickly, but it will be in a U-shape, so, a period of stabilization and then a slow recovery.
There is now a multitude of highly undervalued small biotech companies in the market. Even some companies have their market value below the cash value. I think now is a very good time to invest in good small biotechs that are very undervalued. As an example, Hepion Pharmaceuticals (NASDAQ:HEPA) with a market capitalization of $75 million and cash of almost $100 million is a good example of the latter. Also, BioXcel (NASDAQ:BTAI) with a lot of catalysts to come and yet it has had a cumulative drop of more than 60% in the last few months. I know these two companies well, but there are many examples like these two.
The XBI Index has had an accumulated collapse in the last year of approximately 50%. It is a historic fall because it had never suffered such a collapse before.
Excessive growth during 2020 and early 2021, along with uncertainty about a possible interest rate hike scenario, could be behind this sharp decline.
However, I think the index has already bottomed around 85. The market has already priced in the possible interest rate hike. Furthermore, I do not believe that the Fed will initiate a scenario of long-term interest rate hikes since the sharp rise in inflation has been caused by rises in raw materials and supply problems derived from the pandemic. So I don’t think inflation will last very long. I don’t think there’s a risk of a long-term high-interest rate scenario.
Now is a great time to invest in highly undervalued small biotech companies.