Health stocks are back. But do they have lasting power?

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Healthcare stocks are in the lead. In a few weeks, these little players have become stars. But the big races end on Wall Street, just like in Hollywood. For investors, is the show almost over?

To understand the answer, let’s start at the beginning. The healthcare sector started the year on a weak note after a strong 2022, comparatively. The SPDR healthcare sector exchange-traded fund (ticker: XLV) was only down 3.5% from the S&P 500’s 20%. S&P 500 was up.

But last week, investors poured just under $1 billion into health care equity funds — the first inflow since January and the biggest since November, according to Bank of America.

The sizable sum took last month’s average weekly inflow to a few hundred million dollars, a four-week moving average that had been negative this year. The ETF, which owns insurers such as

UnitedHealth Group

(UNH) and

humane

(HUM) and drug manufacturers, including

Bristol Myers Squibb

(BMY) and

Pfizer

(PFE), gained just under 7% over the past month.

The reason the money came back has to do with the Federal Reserve’s fight against inflation. To start this year, investors bought other sectors, partly in the hope that the Fed would soon stop raising interest rates. A change in central bank strategy, investors assumed, would support the economy. Under this assumption, they exited the very stable healthcare sector and bought more economically sensitive stocks.

Now those stable stocks look a bit more attractive. But after a gain of 7%, how much room is left to make health care work?

The fund’s share price stands at around $134, still below the high waters in the $140s. If the rally continues, the stock price could reach this level, but there is a good chance that investors, as they have done several times in the past year, will sell to drive the price down.

What could lift the stock price – above the $140 mark – is this shaky confidence in the economy. The greater the fear of a downturn, the greater the push toward safe spaces like healthcare.

And it is certainly possible. But Wall Street knows the temperature of recession is rising and falling these days. A reasonable bet is that the rally is heading for an extinction soon.

Yet there’s another reason to consider how long healthcare will remain a market darling. For potential buyers, these stocks don’t seem so cheap anymore.

The fund’s overall forward price-to-earnings multiple is a hair under 18 times, near the S&P 500 just over 18 times, according to FactSet. It’s normal for health names to trade almost in line with the broader market, but they sometimes trade deep discounts.

Higher healthcare multiples look unlikely as investors get lower earnings growth for them; according to FactSet, the healthcare ETF’s expected growth in annualized earnings per share is about 10% for the next three years. The S&P 500 is around 11%.

So the economy and stock prices are signaling that significant near-term transport is probably not in the cards. That doesn’t mean, however, that there aren’t long-term opportunities for investors who are willing to hang in there.

Perhaps the biggest consideration should be the search for new drugs, especially by companies whose patents on blockbuster drugs are soon to expire.

Merck

(MRK), with a market value of $292 million, is an example. The pharmaceutical company just paid nearly $11 billion for Prometheus Biosciences, which has several drugs in the pipeline; one is an ulcerative colitis drug in the third phase of trial results. The next step is approval by the Food and Drug Administration.

Merck will need another big seller by 2028, when the patent for its top-selling cancer treatment, Keytruda, could expire. Today, Keytruda represents more than $20 billion of the company’s $60 billion in annual sales. Prometheus’ ulcerative colitis drug has potential annual revenue of $30 billion, says

Mizuho

analysts.

Merck’s new drug opportunities “could be significant contributors to positive sentiment and valuation expansion,” Mizuho’s Mara Goldstein wrote.

While the deal with Prometheus, which is not profitable, will reduce total profits in the short term, it should increase profits in the long term.

For Merck shares, the deal could boost gains. It’s selling at just over 15 times forward earnings per share, which isn’t bad for the expected 13% annualized EPS growth over the next three years, a rate that could improve thanks to growth. ‘OK. The company continues to increase sales of existing drugs and will resume share buybacks, which reduces the number of shares and increases EPS.

The bottom line, then, is that there’s still room for health care to work with the right game.

But the easy money has really been made. Now finding winners is all about doing your homework on every company that looks interesting.

Write to Jacob Sonenshine at [email protected]