Stocks: Following China's Correction, Will Biotechnology Be Next?

By Alex Dumortier,

The Federal Reserve was sufficiently reassuring for investors' tastes on Wednesday,and a full-blown Greek financial crisis has been averted (or at least postponed), so U.S. stocks are set to record a positive return this week, putting them back to within 1% of their May all-time high.TDow Jones Industrial Average and the broader werebothdown0.35% at 12:30p.m. EDT. The technology-heavy Nasdaq Compositewasdown0.3%.

Chinese stocks, on the other hand, have just put in their worst week since October 2008 -- the month following Lehman Brothers' bankruptcy filing -- with the Shanghai Compositefalling 13.3%, including a 6.4% one-day decline on Friday. At the end of May, the index fell 6.5% in a single day.

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But the environment appears to have shifted since then: Chinese authorities are no longer acting as stock market cheerleaders. This latest development is healthy -- when it comes to inflating bubbles, retail Chinese investors don't need any encouragement! The Shanghai and Shenzhen indexes have both doubled over the past year, after all.

Speaking of excess, though, back on U.S. shores the hit a new record high yesterday. That milestone is not in itself a problem, of course, but there are other worrying signs. Encouraged by the wave of takeovers by traditional pharmaceutical companies, investors appear to be taking bets on the next target, pushing valuations up to extraordinary levels in the process.

On Wednesday, serial acquirer Allergan PLC announced it would pay $2.1 billion to purchase biotech Kythera Biopharmaceuticals, which manufactures a compound that reduces double chins.

Kythera has never been profitable, but at least it has substantial revenue. That isn't the case for , which has an Alzheimer's drug, RVT-101, ready to begin phase 3 trials. The company went public last Thursday, immediately commanding a $2 billion market value.

Axovant was founded by Vivek Ramaswamy, 29, a former hedge fund employee. I have no quarrel with that; Larry Friedhoff, a veteran Alzheimer's drug researcher, is overseeing RVT-101. What I do have a problem with is the following detail, reported by the Financial Times:

Smilar abuses of corporate governance occur all the time, but they are easier to overlook when investors are feeling a bit euphoric and their judgment is impaired by the thought of quick and substantial gains.

Professor Paul Marsh of London Business School, an authority on long-term asset returns,has just completed a historical analysis of all the issues on London's AIM market, a stock market for emerging growth companies, with his colleague Elroy Dimson. One of his conclusions: "People tend to overvalue growth stocks," he said. "They fall too much in love with a growth story, and place too high a price on it."

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Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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