Are Biotechs Bad Medicine for the S&P 500?

The S&P 500  (SNPINDEX: ^GSPC  ) is a closely watched indicator of the U.S. economy that has started to falter over the past few weeks. Specifically, the S&P 500 is now down over 2% in the last month, although it's still up about 15% over the last year. While this recent weakness is likely due to a general correction among large-cap companies following their recording breaking gains, we can probably point to certain groups, such as biotechs, that have been falling faster than others as the culprit. Namely, the iShares Biotech Index (NASDAQ: IBB  ) is down 5% year to date, with most of these losses occurring over the past month.

As the S&P 500 is weighted by market cap, larger companies have a bigger effect on the index's performance. So let's take a closer look at the performance of the three largest biotechs in the S&P 500 -- Gilead Sciences (NASDAQ: GILD  ) , Amgen (NASDAQ: AMGN  ) and Biogen (NASDAQ: BIIB  ) -- to see if they are indeed helping to lead this key index lower.

Gilead has been sinking like a stone
Gilead is the S&P 500's largest biotech with its market cap of over $100 billion. Over the past month, Gilead shares have sunk a whopping 15.3% on the back of the pricing debate for its new hepatitis C drug Sovaldi. As a refresher, political, patient advocate, and consumer groups have all called for Gilead to lower Sovaldi's average price per course of treatment of $84,000. Investors are thus concerned that Gilead will lower the drug's price, in turn lowering revenue for the year. Even more concerning to investors is that this pricing debate over Sovaldi has touched off a wider conversation about drug pricing in general, suggesting to some that the industry's projected forward earnings estimates may be too high over the long term. While any pricing issues beyond Sovaldi remain to be seen, there is no doubt that fear over drug pricing has hurt top biotechs like Gilead. And its large monthly drop has subsequently had a negative impact on the S&P 500.

Amgen also in a freefall
Amgen takes second place in the S&P 500 among biotechs with its $85+ billion market cap. The company's shares have fallen nearly 10% in the past month and 5% in the past week alone. What's particularly interesting to note is that the recent drop gives Amgen a price to earnings ratio, or P/E, of roughly 16.8, and a forward P/E under 13 -- both of these ratios fall well under the industry's historical averages. Moreover, I like the company's growth prospects with evolocumab. As with Gilead, I believe the market is thus ignoring Amgen's potential for top-line growth, showing that sentiment has shifted in dramatic fashion. Before this pullback, the market was more than happy to pay top dollar for forward earnings among biotechs, and that clearly isn't the case any longer. Overall, we can lay some of the blame on the S&P 500's correction at Amgen's doorstep.

Biogen isn't helping matters
Biogen rounds out the top three biotechs in the S&P 500 with its $65.5 billion market cap. However, the company isn't helping to exonerate biotechs from the S&P 500's recent woes, given its 17% nosedive in the past month. In fact, Biogen has been one of the worst performing stocks in the S&P 500 lately. In my view, Biogen's price-to-earnings ratio reflected the sunny optimism of investors before this pullback, and that's why it's one of the steepest decliners now. Even so, Biogen still sports a P/E of 35 and a forward P/E of 19.5. As Mr. Market appears to have soured on paying a premium for biotech earnings in general, there is good reason to believe Biogen could have further to fall.

Foolish wrap-up
Truth be told, the S&P 500 was probably due for a general correction after more than doubling in the past five years. And the fact that biotechs have clearly been aiding this move lower suggests that the theme may be "value" over "growth" for the time being. Going forward, the question thus becomes, can biotech earnings create value? In Gilead's case, some analysts (including me) have argued that the stock is now trading at a forward P/E of 7 based on 2016 earnings. By most standards, such a P/E would be viewed as cheap and Gilead might thus be considered as a value stock. Then again, we are facing a rather moody Mr. Market now, and there's no telling what he thinks is cheap. In other words, we are in the midst of a change in market sentiment, which is impossible to judge in rational terms. As such, you may want to consider the wisdom of employing a dollar-cost averaging strategy and taking a long-term outlook. Changes in sentiment come and go, nicely illustrating why trying to time the market is generally a bad idea.    

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