Charts created using Omega TradeStation 2000i. Chart data supplied by Dial Data

Are Biotech stocks in a bubble? This is a question that is being asked. According to an article by Bloomberg (Biotech Index in Nosebleed Territory - Up 500% In 4-years, Trades At 10X Revenues - Bloomberg Business, March 8, 2015) the 269 Biotech companies that are listed on the NASDAQ are up more than 500% in the past four years. The Biotech companies have the biggest weighting on the NASDAQ at 11.2%.

A 500% gain is impressive. The NASDAQ Biotechnology Index (NBI) is up a more modest 338%. The TSX Health Care Index (THC) is up an even more modest 187% in the same period. It appears that some of the really high flyers are not even in the NBI. As to the THC, it has been led primarily by one stock - Valeant Pharmaceutical (VRX-TSX). VRX is up 665% in the same period.

So are the Biotech stocks in a bubble? They certainly could be. The NBI according to the Bloomberg article trades at 10 times its annual sales vs. 2.3 times for the broader index. Driving the market higher has been a huge number of blockbuster initial public offerings (IPOs) and instant multi-billion dollar market valuations for companies that don't even have products for sale. Sounds like the internet and high tech companies of the late 1990's. There have also been mergers that have helped push the index higher. The fact that there has been considerable advancement in scientific achievements in the Biotech sphere has been a key driver for the industry.

If Biotech is in a bubble the warning is that bubbles usually end badly. Three of the most famous early bubbles all ended in complete ruin for their investors. The big three all mentioned in Charles McKay's definitive history of early bubbles Extraordinary Popular Delusions and the Madness of Crowds (1841). The big three are Tulipmania (1634-1638), the Mississippi Bubble (1719-1720) and the South Sea Bubble (1720). The famous bubbles of the 20th century have been the bull market of the roaring twenties (1924-1929), the Japanese bubble (1984-1989), the gold bubble 1976-1980 and the NASDAQ high tech/internet bubble (1995-2000).

So how big of bubble were those 20th century bubbles? The roaring twenties saw the Dow Jones Industrials (DJI) rise 337%. The crash that followed that gain saw the DJI fall 89%. It took the DJI 25 years before it took out the 1929 high. The Japanese bubble saw the Tokyo Nikkei Dow (TNA) rise 301%. The crash followed that gain saw the TNA fall 64% over the next two years. 25 years later the TNA is still down 49% and at its lowest point the TNA was down 80%.

The gold bubble of the late 1970's saw gold rise 766%. It took gold 28 years to regain the highs of January 1980. At its lowest point in 1999, gold had fallen 71% from its January 1980 high. The NASDAQ high tech/internet bubble of the late 1990's rose 623%. At its lowest point in 2002, the NASDAQ crash had dropped the index 78%. The NASDAQ has still not regained the 2000 high although thanks to the strong Biotech market the NASDAQ has come close in 2015.

Below are the charts of Tulipmania and the South Sea Company that was at the heart of the South Sea bubble. They are interesting lessons of bubbles gone awry. As history would appear to suggest, what goes up comes down even faster. Not only does it come down faster - one could be wiped out completely.

For a more recent comparison one might look at the TSX Venture Exchange (CDNX). The CDNX has fallen 80% from its highs back in 2007 or 72% from its 2011 highs. Indeed the CDNX fell 80% during the 2008 financial crash than rallied 265% into a high in 2011 before collapsing once again. Numerous individual junior exploration stocks are down 90% from their highs. Yet at no time was the CDNX considered to be in a bubble at its highs back in 2011 or even in 2007 as given the price of gold at the time and based on their assets in the ground there were few companies trading at excess valuations. By numerous measurements today's CDNX is quite cheap as many of the same companies are trading with no or little value given to their assets in the ground. Yet few are paying any attention to the CDNX and the numerous resource based stocks that make up the index.

Ok the Biotech market is not Tulipmania or the South Sea Bubble. But with a gain of 338% in the past four years the NBI is in DJI roaring twenties and Japanese bubble territory. But then it there is still a ways to go to get into gold or the NASDAQ high tech/internet bubble territory. Being up this much is not necessarily a sign that the top is in as technically the NBI is in a powerful uptrend with few signs of topping action. But the NBI and the Biotech stocks are by previous examples in bubble territory.

Source: Elliot Wave International

Since the 2011 low, the NASDAQ is up 108%. From the 2009 low, the NASDAQ is up 287%. The S&P 500 is up 215% since the 2009 low. These are large gains but they do not necessarily put them in bubble territory. A better comparison for the NASDAQ and the S&P 500 is the gold market from 2008 to 2011. Gold gained 180% during that period less than what the NASDAQ and S&P 500 are up today. Again a solid gain but at no point did gold enter bubble territory at its high in September 2011 even though many claimed the market was frothy and in a bubble.

Maybe the best evaluation as to whether the Biotech stocks are in a bubble is their valuations. The Biotech sector has been the best performer for 5 consecutive years 2011-2015. Yet according to analysts 109 of the 150 companies that make up the NBI lost money in the past year. There have been IPOs of companies that have gained instant $1 billion plus market caps even though they have no earnings and some no revenue. In 2014 there were 82 IPOs eclipsing the peak of 67 IPOs seen in 2000 at the height of the high tech/internet bubble. According to analysts there have been a further 12 IPOs in 2015. Some 44 Biotech companies have market caps over $2 billion yet in 2014, there were only 26 and in 2011, there were just 14.

Some claim that these are signs of a bubble. And they may well be right. But consider further. In 2014 of the 150 companies in the NBI, 18 companies generated 83% of the earnings. If 109 companies in the NBI lost money in 2014, that means that only 41 were profitable.

The bulls agree that Biotech is in a boom but that it is justified given that it is an innovating sector in an area that is growing and has needs. As a result Biotech is an area that would always command pricing power and there will always be a steady pipeline of projects. As a result, it is a sector that attracts funds as it delivers strong returns. The bears ask how sustainable is this in a sector where many lose money and some don't even have revenues and where many have become quite overvalued.

The Biotech sector can continue to rise as long as the broader market continues to rise. But the upward trajectory can end abruptly and unexpectedly. The roaring twenties bubble ended in the 1929 stock market crash and the Great Depression. The Japanese bubble ended abruptly in a crash as well resulting in what has become known as the Japanese long recession. The gold bubble ended in a crash when Fed Chairman Paul Volker raised interest rates to 20% and gold entered a long period of ongoing decline. The high tech/internet bubble ended badly as well and numerous high flying stocks disappeared for good and the sector has yet to regain its highs fifteen years later. There was also the 2008 financial crash triggered by the collapse of the sub-prime loans market a bursting of a so-called housing bubble and the collapse of brokerage giant Lehman Brothers. And let's not forget the investors in Tulipmania and the South Sea bubble that left many in financial ruin.

Maybe it's the old adage to buy when its cheap and sell when it is expensive. Whether the Biotech sector has reached its final top is beside the point. The sector has become overvalued on both a fundamental and technical basis. What it awaits is a trigger that results in a crash and another round of ruined investors. Below is a chart of the not quite as "bubbly" TSX Health Care Index. Even the THC on a technical basis is looking frothy. Buyer beware.

Charts created using Omega TradeStation 2000i. Chart data supplied by Dial Data