During her report to Congress today, Federal Reserve Chairwoman Janet Yellen suggested that small cap biotech stocks might be overvalued. She is the most important person in finance so I would take her comments very seriously. Here's why:
1. She is by far the most important person in finance. Many market participants listen to what she says and base investment decisions off of it.
I am seeing a lot of comments on Twitter to the effect that “small cap biotech stocks do not have P/E ratios” or “what does she know about biotech.” Those are fair points, but unfortunately they do not matter. Her opinion, whether you think it is misguided or not, matters a lot. She is the most important person in finance so what she says is surely going to affect sentiment. We need generalist funds to participate in biotech for the sector to be strong over the short-term, but they are likely to be influenced by this.
2. Her remarks about biotech were not an accident, they were meant to send a message.
The comments about small cap biotech (and social media) stocks being “substantially stretched” were not said off-the-cuff during Q&A. They were a part of her formal report. You can bet the Federal Reserve staff carefully pours over every word before submitting it. That raises the importance because it means they were meant to send a specific message to the market. The Fed has small cap biotech on their radar, thinks the sector is over-valued, and would prefer that it cooled off a little. That is no small thing to ignore. You have probably heard the phrase "don't fight the Fed" before?
3. NY Fed President William Dudley said the same thing about biotech in March, and it likely had a big impact on sentiment about the sector.
Many laughed when NY Fed President William Dudley gave very similar comments about biotech stocks during a March 6th speech, but look at what happened to the sector afterwards:
While markets move for many reasons and it is impossible to credit him with the decline, I would not write it off as a coincidence. His comments turned a lot of heads. The infamous Waxman Gilead letter did not happen until later that month (March 21st) so biotech was already headed down beforehand. It is possible that Dudley’s comments contributed to the decline significantly, and maybe set it off. Chairwoman Yellen’s words carry a lot more weight than his.
4. Only fundamentals matter over the medium and long term, but this can definitely have a real impact over the short-term.
I am not suggesting that investors should overreact to the news. Only fundamentals matter over the long-term. However, this definitely has the potential to put the sector out of favor for a while so I would take it seriously. Just be very careful, for example, if you are on margin or have high amounts of leverage. It would be great if biotech bounces right back tomorrow, but I would be very surprised if it does. We likely will be in for some choppy trading for at least a little while after this. Turn the news into a positive and use it as a wake-up call to reassess your holdings. As is always the case in investing, it is best to plan for the worst and hope for the best.