One of the defensive speculative strategies I've discussed over the past few years is allocating capital to super-cyclical stocks, with a focus on biotechnology.
Although this sector is typically discussed as a growth area, the fact that the viability of the sector from a business standpoint and the performance of the underlying stocks is relatively less sensitive to immediate economic activity in comparison to the bulk of the S&P 500 also warrants considering it as defensive growth opportunities.
Having said that, as I discussed earlier this week, the performance of all of the stocks that may be considered defensive, including biotechnology, have now been bid up to prices that are beyond even super-cyclical economic projections. Speculators in these areas need to be aware that the risk of a cyclical drawdown has grown substantially and may occur as a result of an increase in aggregate economic activity.
As a matter of fact, due to the relative underperformance of economically sensitive stocks over the past few years, if evidence of a rebound in economic activity increases, the prospect for profit-taking by those having invested in the biotechnology space as preferential to the more economically sensitive sectors may take profits and reallocate capital to consumer discretionary stocks. The premise is that their associated businesses may be expected to benefit from an increase in consumption.
This is unlikely to occur, but if it does, a cyclical peak-to-trough drawdown of 50% or more in the biotechnology space is reasonable. But the long-term prospects for the businesses and their stocks are still stellar and in my opinion continue to be better than any other sector.
The reason I bring this up is that many speculators claim an understanding of the probability of that occurrence and an ability to hold through the process as it occurs. But my experience has been that many claiming to be comfortable with a drawdown of this magnitude discover that when it actually happens they're not as comfortable as they thought.
The stocks in this space may generally be divided into two categories; the 10 largest and the rest.
The 10 largest are best represented by the holdings iShares Nasdaq Biotechnology (IBB), with the largest of the remainder being represented by the holdings of SPDR S&P Biotech ETF (XBI).
One of the interesting aspects of the performance of these two has been that the stocks owned by IBB, and IBB itself, have collectively outperformed the smaller issues in the portfolio of XBI and XBI itself.
The volatility of the smaller issues is also greater, as was indicated by a decline in both ETFs during a roughly-two-month period earlier this year, between March and May, with IBB down 20% and XBI down 27%.
The greater performance with less volatility in the larger issues is also indicative of the institutional shift into larger-cap issues I referenced in the column on the risks of defensive investing earlier this week.
Some percentage of the capital allocated to these stocks is indicative of a flight to safety, as money managers concerns about economic activity and the stocks most sensitive to it has increasingly grown over the past few years.
But that capital may also be considered to be temporarily parked until there is clarity on economic activity and indications of an immediate increase in it are evident.
Interestingly, this means that super-cyclicals may continue to outperform if economic activity does not increase. But because these stocks have already been bid even beyond super-cyclical economic expectations it is possible that speculators will begin to take profits and reallocate the proceeds back into consumer discretionary stocks, even without an increase in economic activity, simply because of the relative underperformance of that sector.
But what is equally probable is a migration away from biotechnology and to general technology because the relative performance of those stocks since the 2008 financial crisis, although greater than every other sector, has also been dwarfed by the biotechnology space.
In the past five years, IBB is up 273% and XBI is up 232%, while the Technology Select Sector SPDR ETF (XLK), which holds the largest general technology stocks has only increased 85%.
The bottom line for speculators in biotechnology is that its performance over the past five years has outpaced every other sector by such a large margin that it is highly improbable that it will continue to do so. The risk of a drawdown in that space as a result of money managers simply reallocating for risk adjustment, even without any change in economic expectations, is substantial.