Why Janet Yellen is wrong about biotech and social media

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After Janet Yellen said earlier this month that the valuations on some social media and biotech stocks are "stretched," investors had a moment of reflection, driving down share prices over concerns that the Federal Reserve chair just might be right.

The Solactive Social Media Index, which consists of companies such as Facebook Inc., LinkedIn Corp. and Twitter Inc., fell 2.6 per cent over three days following the remarks; and the Nasdaq Biotechnology Index (Celgene Corp., Gilead Sciences Inc.) fell 5.7 per cent over three days.

But the two sectors have held up remarkably well since then and the broader S&P 500 has gone on to hit record highs. Is Ms. Yellen wrong?

Jonathan Golub, chief U.S. market strategist at RBC Dominion Securities, believes that the fuss over valuations is certainly misplaced. In a note, he made the case in favour of biotech and Internet stocks, drawing upon five main points.

1. "The market does not appear frothy."
Mr. Golub is talking about the overall market here, and backs up his assessment in an interesting way: He notes that the spread between stocks with the highest price-to-earnings ratios and the lowest P/E ratios is tighter than normal and bears little resemblance to the massive spreads seen in the late 1990s during the tech bubble.

2. "Secular growth is attractive in low GDP environment."
In other words, when the global economy, and developed markets in particular, aren't growing at a brisk pace, investors should be willing to pay a premium for companies that are growing fast.

3. "Valuations are attractive relative to growth prospects."
When you assess biotech and Internet stocks on their projected growth – rather than trailing growth – their valuations look far more reasonable. For example, the S&P 500 is expecting to see earnings on a per-share basis grow 13.5 per cent over the next 12 months.

But biotech stocks and Internet stocks within the S&P 500 are expected to report earnings growth of more than 40 per cent. When you compare this expected growth to their higher P/E ratios using a price-to-earnings growth (or PEG) ratio, biotech and Internet stocks look reasonable.

4. "Multiples for biotech and Internet stocks have declined year-to-date."
That's because earnings have been rising at a faster clip that share prices, resulting in a lower overall P/E ratio.

5. "The current environment bears little resemblance to the tech bubble."
Ms. Yellen's comment about stretched valuations brought to mind former Fed chair Alan Greenspan's "irrational exuberance" warning during the 1990s tech bubble. But Mr. Golub pointed out several differences between then and now.

Today, for example, 79 per cent of the S&P 1500 biotech index is profitable, versus just 52 per cent in 1999; 89 per cent of Internet stocks are now profitable, versus just 67 per cent in 1999.

In terms of valuation, biotech stocks in the S&P 1500 trade at less than 17-time earnings, down from more than 73-times earnings in 1999. For Internet stocks, today's P/E is less than 22 times earnings, versus a P/E of 237 in 1999.

Ms. Yellen, back to you.