Gavekal Capital: Breakdowns in the Health Care Sector

Tuesday, May 19, 2015

Breakdowns in the Health Care Sector

Health care stocks have been the leadership sector in the MSCI World, and many (such as biotech) have reached some pretty elevated valuations.  Most stocks in the sector have been in multi-year bull markets trends, outperforming the MSCI All Country World Index  significantly.

In our relative strength point and figure charts we take the daily price in USD of the individual stock and the MSCI ACWI.  We calculate the ratio and the measure changes in 2.5% increments.  Each X is a 2.5% relative outperformance and each O is a 2.5% relative underperformance.  We impose a 3-box reversal meaning that in order to shift from and ascending column of Xs to a descending column of Os, we must see a 7.5% shift in relative performance.  By measuring price movements in this way, we remove two sources of noise in the fluctuations in stock prices: the movements of a stock attributable to movements in the market as a whole (the beta) and the noise inherent in the movement of individual security prices.  Because trend reversals are a function of changes in relative price trends, time is not a variable.  A reversal can take 3 days or 3 months.  Time is marked in the top of the y-axis and as can be seen, the amount of reversals vary year by year. Generally a stronger bull market trend has fewer reversals in the midst of an uptrend.  Reversals are a proxy for risk, so these point and figure charts measure relative price vs. risk, rather than price vs. time like most charting techniques.

The benefit of our charting system is that it gives us an objective standard of performance.  All stocks are bought with the best of expectations and good fundamental reasons for the investment.  After the investment is made, none of this matters much anymore.  The only thing that matters once one owns a stock is how it performs.  A portfolio of chronically underperforming stocks is bound to underperform.  Managing the performance of a portfolio is relatively straight-forward with a systematic method of measuring the performance of the stocks in it.  Every stock has a role to play in a portfolio, and measuring how it is performing this role is an important element of portfolio management.

There are a handful of health care stocks that have recently broken down.  These stocks have been in multi-year uptrends and so are likely widely held in portfolios.  These stocks appear to be undergoing a major reversal of trend from a structural relative uptrend to a structural relative downtrend.  These stocks should be strongly considered as sources of funds.