The Biotech Bubble May Finally Have Popped

After a remarkable four-year run when biotech startups flooded the IPO pipeline and outperformed nearly every other industry, the party may be over. And what many were increasingly coming to call the biotech bubble may finally have popped.

Since peaking on July 20, the S&P 500 Biotech Index has fallen 23%, twice as much as the broader S&P 500 Index during that period. The Nasdaq Biotech Index, which includes more small-cap issues, has fallen even further: a drop of 27%. Typically, a bear market is measured when prices fall 20% or more over a period of several months.

Over the past year, concerns of a biotech bubble have been rising. Fed Chair Janet Yellen warned last year that “valuation metrics” in biotech stocks “appear substantially stretched”—a bland way of warning about a bubble. In March, news site FierceBiotech conducted an informal survey of readers and found that more than half felt the sector had entered in a bubble.

Meanwhile, biotech IPOs flooded the market–33 went public in the first half of this year (nearly a third of the total) following the 74 in all of 2014. And biotech stocks continued to march higher. In late June, I wrote that investors were growing nervous and the biotech party might be over. And two weeks ago, the CEO of drug giant Roche said bluntly, “I think this bubble will burst at some point.”

He didn’t have to wait long. The fatal pin prick came from a drug company few had heard of. In mid-September, HIV activists began complaining that Turing Pharmaceuticals raised the price of a 30-year old drug by 5,000% to $750 per pill. The drug, called Daraprim, treated a common parasite that affects people with weakened immune systems.

Turing CEO and ex-hedge fund manager Martin Shkreli had engaged in this kind of price gouging before, and when FierceBiotech’s editor called him out, Shkreli lashed back, calling him a “moron” on Twitter. After the New York Times ran a story on Turing and other drug companies that jacked up drug prices, things got much worse. Hilary Clinton tweeted her vow to take on pricing she deemed “outrageous.”

And that was all it took. After four years when the S&P and Nasdaq biotech indexes both rose as much as 300%, the great rally was undone with a single tweet. This is how bubbles often begin to burst. Not with some momentous and market-shaking change, but a single straw on the back of an overpriced sector that investors have been secretly, quietly been jittery about for months.

Shkreli was merely the poster child of a growing practice of companies buying old drugs and raising prices, which they defend—implausibly—by arguing it will finance new drug development. Another firm, Rodelis Therapeutics, also raised the price of a tuberculosis drug it bought to $10,000 from $500 but backed off last week. Canada’s Valeant Pharmaceuticals bought two heart drugs and boosted their prices by as much as 525%. A bottle of Doxycycline, and old and common antibiotic, went from $20 in 2013 to nearly $2,000 the next year.

The Nasdaq Biotech Index slid 6% Monday alone after Democrats agitated to have Shkreli and Valeant CEO Michael Pearson testify before Congress about what some term profiteering. That explains why Valeant’s stock fell 17% Monday, but it doesn’t quite explain why shares of so many other biotech companies also tumbled badly.

Most likely, the price gouging taps into an uneasy sense among American consumers that drug prices in general have been rising much faster than inflation for years. It’s not clear whether Turing and Valeant are part of a disturbing trend of a few bad apples buying older drugs to gouge their prices or whether they are the worst excesses of an industry-wide practice of inflating drug prices purely for profit. The industry’s opacity adds to uncertainty. And uncertainty fuels stock selloffs.

When bubbles end, such nuances don’t matter, at least at first. The selling is broad based as investors react less to the threat of new drug regulation and more to the fact that the sector has been overpriced. At the July peak, the iShares ETF based on the Nasdaq Biotech Index was trading at 58 times its forward earnings, well above the ratio for the broader market.

The problem with the broad-based selling, however, is not all stocks in the sector are overvalued—including many of its leaders. Amgen is now trading at 14 times its 2015 estimated earnings, while Biogen is trading at 17 times earnings, and Gilead Sciences at a mere 8 times 2015 earnings. All three have been knocked down between 8% and 10% during the past week.

JP Morgan said Monday that “biotech fundamentals remain strong with likely NO near-term fundamental changes on the horizon” but noted prices could remain volatile – which is an analyst euphemism for further declines. Biotech bulls have long resisted the idea of a bubble in the sector, citing a new breed of therapies relying on gene-based research and the FDA’s inclination to approve more drugs.

The silver lining from the biotech selloff is that it could leave some of its larger, more proven companies at an attractive valuation. That silver lining applies in particular to old-school Big Pharma companies like Roche and Pfizer, which have held off on buying biotech companies because of outsize valuations. If they get much cheaper, it could trigger a wave of acquisitions by Big Pharma.

Unless, of course, the end of the biotech bubble brings a hard fall. Severin Schwan, the Roche CEO who predicted a bursting bubble in the overvalued sector, also lamented, “The more time goes by, the more I am worried that this whole thing will collapse at some point and it will not be not good for the industry if there is too much volatility.”

It’s still too early to predict such a collapse. What’s clear is that the sentiment among biotech investors has shifted abruptly in the past two weeks, with few buyers ready to step in to seek out bargains. Promising companies that have drugs likely to meet regulatory approval in coming years may survive or be bought out. Unless things stabilize in coming weeks, many of the others may find themselves out in the cold.