Attempting to call the bottom in a financial asset that is under considerable pressure is always a tricky and dangerous proposition. As you enter the initial oversold stage, the first reaction for many is to immediately step in with buy orders, viewing it as a long-awaited opportunity. While this is usually the right strategy when you have a bullish uptrend at your back, it becomes a bit more treacherous when it’s undergoing distribution. Case in point – the Health Care sector, in particular the Managed Care stocks. We discussed their worrisome price action a few weeks back (A Former Darling Treads on Thin Ice), and regardless of what is behind this move, the oversold condition of today is vastly different from those that had developed back in January and December of last year. The prior two still had a supportive trend, while today’s is occurring in what looks to be a meaningful top. Sure - the violent sell off will likely be met with sharp mean reverting moves, but given the deterioration, and until trend and momentum indicators improve, I’m inclined to lighten up into strength as opposed to viewing weakness as an opportunity increase exposure.
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Despite the broader market’s unrelenting climb since the start of the year, Health Care has struggled to keep pace - giving back roughly half of the outperformance that the sector generated in the back half of last year. Biotech is part of it, but it is the sharp deterioration in trend for the Managed Care companies that had me on edge. Strong leadership for years, investors have a ton of unrealized profits imbedded in these names - if the bulls can’t stem the recent decline and hold support, the unwind could get ugly. I’ll be keeping a close eye on the bellwether of the group, UNH and the growing importance of its crucial support in the low $230s.
Like almost everything else in this market, the start of the year has helped to normalize the pain experienced by most of the charts in December, with indices, sectors and stocks all reverting right back into heavy resistance zones. Health Care has had strong leadership, but the sector has given back a decent chunk of its outperformance over the past month as investors rotated to the beaten up, more cyclical segments of the market. This has pushed the sector’s relative performance down into a solid support level, and if my broader concerns about risk assets come to fruition, I would expect relative performance to regain its mojo. Equipment & Supplies, Life Sciences & Tools and Providers & Services (ex-Distributors) remain leadership but selectivity is key when flipping through the charts of pharmaceuticals or biotech. Among the many trends that have broken and bounced right back to the scene of the crime is that of style. Growth has regained half of what it lost to value, and with the former largely influenced by biotech and the latter pharma, the call on style comes down to a bet on these two groups.
The heightened volatility of the past few weeks has only reinforced the leadership relative trends that have been percolating beneath the surface for months. Pharma, Providers & Services and Equipment & Supplies have done an admirable job maintaining their momentum despite the market’s growing risk aversion. The same cannot be said of biotech, as the cracks discussed over the summer have resolved themselves sharply to the downside. This correction has provided investors with a deeply oversold condition at multi-year support, which when combined with favorable seasonality and the thick of earnings season, should provide the impetus for some much-needed relief. I view this reversal in sentiment as a buying opportunity, but the longer that upward price momentum fails to develop, one must start questioning whether the best days for the group are a thing of the past.
While seasonality has failed to play out for the market generally, one of the leaders within Health Care has not been so lucky. Biotech tends to face a bumpy road August through October, and while absolute trends look to be consolidating for the equal-weighted S&P Select Index (118 members) the real story has been the deterioration in relative strength for the average stock. Skewed to the SMID caps, this slippage is one of the drivers behind Pharma and value’s emerging momentum.
The bifurcation among capitalizations within the Health Care sector is a stark reminder of the value that active management can provide. Simply buying the XLV (Health Care Select Sector) back in mid-’15 has been a money losing proposition thanks to the underperformance of many key large cap constituents. The complete opposite has been the case as you move away from heavy index weights and down the capitalization spectrum – where bullish trends and momentum have been abundant for active investors, small caps in particular. Biotech is the poster child of this divergent behavior, where the techincals have been, and continue to be, supportive of a long XBI (equal-weight)/short IBB (cap-weight) approach. That said, I want to highlight a pattern that has developed over the past decade (chart below), where the average biotech stocks rips in July, only to give a fair amount of these gains back during the August – October time frame.
Similar to the broader tape, the past few months have not been kind to the health care sector, as each oversold rally has been met with a healthy dose of supply. With trends under duress on both an absolute and relative basis, we would look towards Equipment & Supplies (e.g. DHR, VAR, SYK, IDXX, ISRG) and Managed Care (ANTM, HUM, UNH, CNC) for leadership. I would also point you down the capitalization spectrum, where small cap health care continues to dramatically outpace their large and mid-cap colleagues. For me, however, the most intriguing development of the past month are the early signs that growth is starting to give way to value. Make no mistake - regardless of style trends lacking the attributes I favor - it looks like some mean reversion is in order. Flipping through the charts of the growth constituents, a fair number look quite vulnerable to meaningful downside moves. I’ve included my favorites in today’s note.
A couple of weeks ago Chris Senyek published an interesting note on a fundamental attribute, which should help provide alpha regardless of the market backdrop. In the note - Portfolio Strategy Weekly Report: Stock Picker's Alert: Buy 'ICE' - Incremental Free Cash Flow - Buy 'ICE' in a 'Risk On, Risk Off' Environment, he recommended that investors consider accumulating positions in ‘High ICE’ companies, which is based on his proprietary model which identifies names generating the highest incremental free cash flow returns on equity. Historically, this strategy has worked across the market cycle. On the flip side, a low ICE reading coupled with elevated valuation does not bode well for forward returns. Chris’ note provided a number of long and short candidates, a handful of which were confirmed by the technicals (ICE in the Spring?).
Every once in a while, a stock checks all of the boxes from a fundamental, quantitative and technical perspective. HCA Healthcare is one such example :
•Outperform rated by Justin Lake (Takeaways from Nashville: HCA / LPNT / ACHC / SRGY)
•Senyek and team: “HCA screens attractively on valuation and capital allocation and is a “1” in our Stock Idea Model” (Senyek's Stock Screens)
•Flagged by Wolfe’s QES team for recent insider purchases (Seeking Alpha from Insider Transactions)
•Technically, breaking out from multi-year base with accelerating relative performance
Since peaking back in the summer of ‘15, it has been an interesting ride for biotech to say the least, but the group (at least on an equally weighted basis) finally broke out to fresh all-time highs, helping to confirm our bullish view. While trends and momentum continue to favor equal over cap and with it small over large, I’m also cognizant that the driver of this outperformance will be the hardest hit during the next overbought consolidation, an environment we’re firmly in following yesterday’s price action.
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