The sharp decline in health care stocks this year is only the beginning. The US health care system is likely in the last phase of a bubble. Here we will lay out arguments for why investors should be significantly underweight or even short the US health care system.
What makes 2017 different from the past 20 years, when this bubble was built, is the new US presidency period and that health care prices have finally reached unsustainable levels which will cause both popular anger and intense focus from politicians next year.
Insulin drug prices
Basically, their list price is up 700% adjusted for inflation over the past 20 years. But what is more interesting is the fact that the net price is flat or slightly lower compared to 2009, according to Eli Lilly.
So the majority of price hikes has gone to health insurers, pharmacy benefit management, and hospitals because of a very complicated system with many rules and rebates.
In addition, the insulin drug prices in the US are almost seven times higher than in France highlighting the fact that US drug prices are at unsustainable levels.
The chart below shows the rise in US medical care costs relative to inflation, so the real rise in medical care costs. From 1947 to 2016, medical care costs have risen 217% relative to overall inflation.
The three most important events in the recent history of US health care costs are 1966 when Medicare and Medicaid were introduced. Over the following years, costs rose significantly faster than in the previous 20 years before the amendment.
In 1981, health care providers began hiking rates dramatically when they sensed that the Reagan administration would remove the federal rate regulation on the industry.
Throughout the 1980s a series of bills were enacted to try curb rising health care costs but as the chart shows, none of them helped. In 2010, Obamacare was enacted and it was phased in around early 2014.
Despite the stated goal of reducing health care costs they have actually begun re-accelerating again.
The bigger point is that this divergence cannot continue forever. it's comparable to the real estate bubble. Prices can only go as high as disposable income can sustain. In our view, we are getting close to that inflection point in health care costs.
Doctors' pay and inefficiency
There are number of drivers behind the rising costs. The obvious, but also the most complex to understand, is the relationship between Medicare, rebates on drugs, and the health insurers which prevent transparency about costs and lead to administrative overhead expenses that are high compared to other OECD countries.
Doctors are paid five times higher than the average patient, which is around three times higher than in comparable western countries... which obviously adds to the rising costs.
Health care providers' profit growth unsustainable
While drugmakers are not without guilt in this unsustainable bubble, they are not capturing their price hikes because these are eaten up by rebates made to US health care providers. The chart below shows the relative growth of EBITDA and sales among US health care providers compared to S&P 500 companies and also their relative share price performance.
From 2005 and onward, the industry's profit and sales growth has significantly outpaced the average and their share price performance has also been phenomenal compared against the S&P 500.
It's rare that an industry's operating profit growth can continuously outperform the average by around 11% per year without causing any trouble. In this case, it's leading to popular anger because health care is perceived as universal and something people should have access to.
When the working/middle-class families in the US have difficulties paying their health care costs, then it's a sign that the profit capture may has reached its climax. We saw the same with the financial sector...
It's very likely that whether we get a Clinton or Trump administration, rising health care costs will be one of the biggest topics of 2017. The nature of the issue could also prove sufficient to gather support for reforms across both parties in both chambers of Congress.
— Edited by Michael McKenna
Peter Garnry is head of equity strategy at Saxo Bank