After being sucked dry by the "weight loss drug duo," the US medical technology sector is expected to stage a major comeback next year.

Almost no one on Wall Street expected the frenzy over weight loss therapies to make Eli Lilly (LLY.US) and Novo Nordisk (NVO.US) the two most valuable pharmaceutical companies. At the beginning of this year, analysts predicted that Lilly's stock price would rise by about 8%, less than half of Wall Street's expectations for the overall market. Even the most optimistic forecast, by Morgan Stanley analyst Terence Flynn, only projected a 20% increase. In contrast, the company's stock price has soared by over 50% so far this year, increasing its market value by nearly $200 billion.

However, the performance of other healthcare stocks has been completely different. Medical technology companies, including Insulet (PODD.US) and Baxter International (BAX.US), have suffered heavy losses as investors see the demand for all products, from insulin pumps to knee joint surgeries, being eroded by Novo Nordisk's weight loss drugs Ozempic and Wegovy, as well as Lilly's competing weight loss drugs Mounjaro and Zepbound. In addition, Pfizer (PFE.US) and Moderna (MRNA.US) are about to experience record declines, leading to the first consecutive annual losses in the U.S. healthcare industry in over 20 years.

Next year, political risks and the development of weight loss drugs will keep investors cautious. Jared Holz, a strategist at Mizuho Securities, said, "It's a tricky backdrop. In my view, there aren't that many stocks trading below their fair value. Most of the stocks in this industry seem to be priced reasonably."

Due to the underperformance of healthcare stocks compared to the S&P 500 index, it has recorded its worst performance in nearly 25 years. Nevertheless, some investors expect healthcare stocks to regain lost ground as the hype around weight loss drugs cools down. Holz also stated that with equipment manufacturers rebounding at least 30% from their lows, "the doomsday scenario is no longer in play."

Shams Afzal, portfolio manager at investment advisory firm Carnegie Investment Counsel, believes that the pricing of obesity drug manufacturers is perfect. Lilly's stock is expected to have a price-to-earnings ratio of about 46 times. Afzal said, "This is still largely a stock picker's market. If the overall market continues to rise, healthcare will have a fair share of the burden to make up for the losses in 2023.

Biotech and Medical Device Stocks Expected to Rebound Next Year

Some people believe that there is further room for recovery in medical device and biotech stocks. Baird healthcare expert Mike Perrone said, "These two sub-sectors are most likely to improve from their current low levels. If the economy slows down, they hope to strengthen their defense, and healthcare is a good defensive sector." Decades of high interest rates and a series of poor clinical trial data have weighed on high-risk, high-return biotech companies, allowing some of the risks in the industry to be cleared. Last week, the Federal Reserve hinted at multiple rate cuts next year, wiping out the decline in the SPDR SP Biotech ETF that has been closely watched this year. Over the past two years, this equal-weighted ETF has fallen by more than 20% annually.

Bank of America analysts have listed BridgeBio Pharma (BBIO.US) and Rocket Pharmaceuticals (RCKT.US) as top picks. Afzal is optimistic about the prospects of Stryker Corporation (SYK.US) and Abbott Laboratories (ABT.US) because the aging population is driving the use of a range of medical devices.

The challenges of the macroeconomic headwinds have put pressure on laboratory tools and services providers. Equipment manufacturers selling laboratory equipment and supplies to drug developers are also facing the problem of slowing spending by biopharmaceutical companies.

Goldman Sachs analyst Asad Haider predicts that the life science tools sector will perform well next year, while health insurance and dental stocks will face a more challenging backdrop. They expect bioprocessor company Avantor (AVTR.US) to be one of the first tool companies to start recovering.

Large Pharmaceutical Companies May Underperform Next Year

Strategists and portfolio managers advise avoiding stocks of large pharmaceutical companies. Although the weight loss drug market is expected to eventually reach $100 billion, many investors expect these pharmaceutical companies to lag behind by 2024. The question remains whether they can meet the huge demand for these drugs and achieve broad commercial coverage. Afzal said, "If they fail to deliver on execution, then the target market becomes irrelevant. It's time to demonstrate the management's capabilities." The US government's plan to negotiate prescription drug prices also threatens the future profits of large pharmaceutical companies. The pressure to find new sources of revenue is increasing as the patents for popular drugs are about to expire.

This is expected to reignite the wave of mergers and acquisitions. According to institutional data, 16 deals worth $1 billion or more were announced or completed in the first 9 months of this year, consistent with 2022 and far below the peak in 2015. However, the massive deals by Pfizer and Amgen have cleared regulatory hurdles and sparked optimism. Lis Agosto, Senior Healthcare Analyst at ETF company Global X, said, "We have seen that some larger-scale acquisition deals have been completed with minimal or less concessions than expected, indicating that the market may rebound."