Street Talk: Summer No Picnic for Investors

It's been tough to be an optimist these days. The stock market has been taking a pounding of late, the financial equivalent of going 15 rounds with Joe Frazier in his prime.

Brian O'Connell

In early August, the Dow Jones Industrial Average (DJIA) gave back 1,400 points on increased fears over a worldwide credit crash. With the subprime mortgage lending mass spilling into the more traditional lending market, Wall Street analysts are fearful that tightened credit on the part of lenders and a lock down on spending by jittery consumers will give the stock market and the US economy a 1–2 punch that will put both on the canvas faster than you can say "Smokin' Joe."

Let's take a look at the financial markets and see how all this might play out, and how it might affect the life sciences industry.

CREDIT WOES COULD AFFECT BIOTECH

August 9, 2007, was a tough day on Wall Street, with stocks falling 400 points on increased credit concerns over the struggling mortgage lending market. On the same day, AIG released a report showing that borrowers in the category just above subprime were showing increased residential mortgage delinquencies.

AIG is the world's largest insurance company and will have its hands full if lenders can't collect from borrowers. It's also one of the largest mortgage lenders in the world. The company reported that more than 10% of its subprime mortgages were 60 days overdue, while 4.6% in the category just above subprime were late during the second quarter. Also, total delinquencies in AIG's $25.9 billion mortgage insurance portfolio clocked in at 2.5%.

According to AIG, delinquency rates for first mortgages, which represent 90% of AIG's domestic mortgage business, also jumped to 3.89% in June, up from 3.56% in April. Although second-lien mortgages only made up 10% of AIG's mortgage insurance portfolio, that segment incurred $159 million in losses during the second quarter. These mortgages are susceptible to defaults and are especially sensitive to falling home values, the company said.

Can the credit crunch spill over into the biopharmaceutical industry? Sure. With the money supply tightened, many companies, especially younger and less cash-rich companies, will find it more difficult to raise the capital they need to find new drugs, develop new markets, and keep hiring good people.

Also, if stocks continue to slide, shareholders may decide to cut their losses and sell their life sciences stocks, opting instead to put their money into more cautious portfolios like cash or bonds. That will cut into the operating capital and the revenues of publicly traded biopharmaceutical companies, who, in turn, will decrease investments in research spending, hiring, and other key operational areas.

VENTURE INVESTING

With credit tight, and the memories of the 1990s, when billions were lost in Internet companies, venture capitalists are reluctant to fund new companies in such a bearish financial climate.

Again, the markets are taking their lead from the housing market, which is traditionally a good benchmark for the economy as a whole. Economist Robert Samuelson, writing in the August 9, 2007, edition of Investor's Business Daily, said that the real estate market had added, on average, 30,000 new jobs per month in the past few years. But with the housing market in sick bay, those numbers have flipped, and housing industry companies have let go an average of 15,000 employees per month in 2007.

Back in the late 90s, venture capitalists were waving checkbooks at any new firm with a passable idea. Over $100 billion was sunk into such companies from 1998 to 2000. According to Samuelson, this number is down significantly 10 years later, with 2007 and 2008 shaping into an even thinner period for venture investment.

BIOTECH INDEX DOWN

The summer has traditionally been a downer for the life sciences industry. Although in 2007 the DJIA has inched into positive territory (about 2% for the year, and about 10% from July 2006 through July 2007), biopharmaceutical stocks have struggled. In four of the past six years, the Nasdaq Biotechnology Index (NBI) has declined by an average of 14% in those years in which the index fell. Through mid-August, the NBI is down about 2% for the summer months (so far).

Consequently, with a lousy track record in summer months, and a July–August market timeframe that has veered decidedly bearish over the credit crunch, it's difficult to envision a scenario where biopharmaceutical stocks overperform. More likely, biopharmaceutical stocks will continue to wilt in the late summer sun and hope for a comeback in the fall—or more likely, 2008. An optimist would say that the biopharmaceutical market has no place to go but up. Bellwether industry companies like Genentech and Human Genome Sciences were trading near or at 52-week lows in August, but I'd expect to see them continue to trade lower, tethered to the misfortunes of the rest of the stock market as the credit and lending debacle plays out.

HOPING FOR A "SOFT" LANDING

This is why I'm down on biopharmaceutical stocks for the rest of the year. The credit crunch is a portfolio-crushing bogeyman that has come out of the closet in the dead of night with mayhem on its mind. Hyperbole? Maybe.

It's just that, by and large, credit crunches are like hurricanes. They don't come around that often, but when they do, they leave a trail of destruction in their wake. So on the surface, it would appear silly to tie the biotech market to the unraveling credit markets. But, on closer examination, there's a strong bond between the two.

After all, what do biotech companies need more than anything else? A dependable and plentiful money pipeline. Operating capital is the lifeblood of the life sciences industry. But in a period of "tight" money, where liquidity is difficult to come by, biopharmaceutical firms will find it difficult to find the capital they need to keep going.

Investment guru Alan J. Brochstein, writing in his Bio Investor blog earlier this summer, said that the scenario is a painful one for biopharmaceutical companies—akin to keeping water away from a man stranded in the hot desert.

"The linkages elude traditional finance theory, but they are quite clear," he wrote. "On the one hand, speculative biotech companies are in constant need of capital (and capital's cost is going up). On the other hand, liquidity is shrinking and the cost of owning risky securities is rising rapidly. The first point is rather obvious: Biotech companies in development burn cash, causing them to sell bonds or stock to finance their future growth. When it gets more difficult to do, like now, it puts them in a precarious situation of facing funding shortages or having to pay a higher cost."

Brochstein also said that the same guy saddled with a skyrocketing subprime mortgage bill every month is the same guy investing in biopharmaceutical companies. That is, "same guy" being the hedge fund operators who have found themselves stuck holding the bill for the subprime mess (hedge funds are big buyers of loan and credit issues). Needing money fast, the hedge funds should be big sellers for the duration of the credit crisis. That means getting out of positions in other investments, like biotech, to cover their losses in the subprime markets.

It is, I admit, a scary scenario. It's also a scenario that is already starting to play out in the financial markets. It explains why the DJIA had three days in August where it lost more than 200 points daily. It explains why hedge fund managers, facing nerve-wracking margin calls over their failed subprime portfolios, are big sellers of other securities.

IT EXPLAINS A LOT

What to do? Sitting this one out and putting your money into treasuries seems like good common sense. And know that this crisis, too, shall pass. Capital markets have a way of dealing with excess, like we saw with the dotcoms in 1999 and 2000, and with the subprime credit markets today. The market tends to square things away pretty efficiently, even though a lot of people get hurt.

The name of the game is not to be one of those people.

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, Doylestown, PA, 267.880.3144, brian.oco@verizon.net