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When Fed Chair Janet Yellen commented last July about biotechs whose valuations were “substantially stretched, ” we took it with a grain of salt. High valuations in the space are normal, and after a very healthy correction last April, we thought the space still had room to run.

Now, however, we seem to be in the midst of genuine frothiness in biotechs. When we see valuations pricing in the assumed success of drugs that are currently in Phase 1 trials, we know something is amiss. Remember that Phase 1 is the earliest clinical stage, with about an 80 percent chance that the drugs will ultimately fail to be efficacious, or that they will be derailed by side-effects.

If a stock’s valuation is pricing in a 100 percent chance of success for a Phase 1, that’s froth, pure and simple.

We have seen such euphoria not just in smallcap biotechs, but even in their mid- and big cap brethren. Recent price action in the shows that the market may be coming to its senses:

Source: Google Finance

Note, though, that this process may just be beginning: as we write, the index is still up more than 12 percent on the year.

Just as April last year offered a more attractive entry point for biotechs, we think something similar may now be unfolding. We are believers in biotech as a long-term theme, and would be happy to see valuations become a little more grounded. To us, this would ultimately be an opportunity to buy robust, inventive companies whose products will be in increasing demand in a world with aging populations and significant unmet needs in chronic illnesses.

Investment implications: We are fundamentally buyers of biotech weakness. Yet we believe current valuations do indeed express unrealistic euphoria. We will welcome a healthy correction in the space, as we welcomed it last year, as an opportunity to buy some of our favorite names at more reasonable prices. Stay tuned; after a correction, we will have some specific biotech recommendations.

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