Broad-based global equity indexes[1] finished lower after a volatile quarter, as investor sentiment flipped from a potential Fed pivot to a global recession in the face of hawkish central banks around the world. Innovation stocks, particularly those outside the broad-based indexes, rallied during the first half of the quarter before succumbing to significant selling pressure following Chairman Powell’s Jackson Hole speech.
At Jackson Hole, Fed Chairman Powell invoked Chairman Volcker’s name twice directly and twice indirectly (“Keeping At It”), emphasizing that the Fed will continue to raise rates until inflation falls toward 2% on a year-over-year basis. Compared to Volcker’s 2-fold increase from 10% to 20% in the early eighties, Powell has raised the Fed Funds Rate 13-fold from 0.25% to 3.25%. In contrast to the Volcker Fed that battled inflation that had been building for 15 years, the Fed today seems to be responding to COVID-related supply shocks that surfaced in little more than 15 months. In ARK’s view, the Fed is making unanimous decisions based on lagging indicators––employment and headline inflation––despite significant price deflation in the pipeline. From their post-COVID closing price peaks, many commodities are breaking down:[2] gold -18%, copper -31%, lumber -74%, iron ore -45%, DRAM -46%, corn -16%, silver -31%, and Baltic freight rates -65%. Commodities that led the rise in inflation––gold, copper, and lumber––now are down on a year-over-year basis. Although previously an outlier, oil price inflation has decelerated from 99% to 17% on a year-over-year basis since its peak this year.[2] Yet, we believe energy––the strongest-performing sector since the rotation to cyclicals began in February 2021––is likely to be disrupted and disintermediated by autonomous electric vehicles during the next five years.
In our view, the US economy has contracted, inventories have piled up, and long-term inflation fears are overblown. Walmart and Target continue to struggle with inventory buildups that surfaced in the April quarter, while Nike reported a 44% year-over-year inventory increase as revenue growth hobbled along at a 3.6% rate in the August quarter.[3] During the past year, in response to supply bottlenecks caused by the COVID crisis and Russia’s invasion of Ukraine, companies appear to have double- and triple-ordered goods to satisfy stronger-than-expected demand growth that now is diminishing. To attract cautious consumers and clear bloated inventories, retailers could have to slash prices during the holiday season. Furthermore, because the US Dollar has strengthened 17.9% this year and more than 26.1% from its lows last year,[4] a powerful deflationary force is placing significant pressure on emerging and other markets struggling to service dollar-denominated debt. The combination of geopolitical forces and inventory hoarding has pushed US consumer price inflation––a lagging indicator––to 8.2% on a year-over-year basis,[2] a rate that we believe deflationary forces––good, bad, and cyclical––are beginning to unwind. Tesla’s CEO Elon Musk[5] and Doubleline’s CEO Jeff Gundlach[6] recently echoed our concerns about the risk of deflation.
Innovation is the source of good deflation, as learning curves cut costs and increase productivity. Yet, we believe many companies have catered to the short-term-oriented, risk-averse shareholders and have satisfied demands for profits/dividends “now”. On balance, they have leveraged their balance sheets to buy back stock, bolster earnings, and increase dividends. In so doing, many have curtailed investments in innovation and could be ill-prepared for the impact of disintermediation associated with disruptive innovation. Saddled with aging products and services, they could be forced to cut prices to clear unwanted inventories and service debt, causing bad deflation.
Since March 2021, the yield curve[7] has flattened 198 basis points, inverting from +159 to -39 basis points,[8] suggesting that both real growth and inflation could surprise on the low side of expectations. As measured by the University of Michigan, US consumer sentiment[9] remains at levels not seen since the coronavirus pandemic, the 2008-2009 Global Financial Crisis, and the early 1980s when the economy suffered back-to-back recessions as inflation and interest rates hit double digits. Meanwhile, the US consumer saving rate has dropped to 3.5%[10]––the lowest since August 2008––which, when coupled with historically low consumer sentiment, suggests little room, if any, for consumption growth.
If we are correct in our assessment that growth, inflation, or both will surprise on the low side of expectations, scarce double-digit growth opportunities could be rewarded accordingly. The adoption of new technologies typically accelerates during tumultuous times as concerned businesses and consumers change their behavior much more rapidly than otherwise would have been the case. As a result, new leadership tends to surface in the equity market toward the end of a bear market. We believe the coronavirus crisis and Russia’s invasion of Ukraine have transformed the world significantly and permanently, suggesting that many innovation-driven strategies and stocks could be productive holdings during the next five to ten years.
In our view, the wall of worry built on the back of high multiple stocks bodes well for equities in the innovation space. The strongest bull markets do climb a wall of worry, a fact that those making comparisons to the tech and telecom bubble seem to forget. No wall of worry existed or tested the equity market in 1999. This time around, the wall of worry has scaled to enormous heights.
Dominating most broad-based indexes, several mega-cap stocks seem to have lured risk-averse benchmark-sensitive investors into crowded trades and away from emerging growth opportunities centered on disruptive innovation. In our view, investors in broad-based equity indexes seem to be shorting truly disruptive innovation, perhaps inadvertently and, if history is any guide, to their detriment. As a result, they could be missing investment opportunities like the next Amazon, Apple, or Tesla, companies that invested aggressively at the expense of short-term profits. For years, as many investors assumed that it would go bankrupt, Amazon invested with the aim to disrupt legacy brick-and-mortar businesses and capture a disproportionate share of the retail e-commerce opportunity. In the early days, Wall Street also missed the potential of Apple’s iPhone to disrupt Nokia, Samsung, Motorola, and Blackberry. Recently, it also denigrated bitcoin and other cryptoassets as Ponzi schemes. In another example of truly disruptive innovation, traditional auto analysts deemed Tesla as doomed to failure: they did not understand that Tesla was a robotics, energy storage, and artificial intelligence company, not an auto company. While controversial and volatile in the short-term, companies focused on innovation that solves problems and disrupts legacy industries have the potential to surprise on the upside with significant exponential growth trajectories. In our view, active management will play a crucial role during the next five to ten years as some disruptive companies win and others lose in winner-take-most markets.
During the third quarter, the performance of ARK’s ETFs relative to the broad-based indexes was mixed. Among ARK’s actively-managed ETFs, three underperformed, two outperformed, and one outperformed the MSCI World Index but underperformed the S&P 500 Index. Among ARK’s indexed ETFs, one underperformed and one had mixed performance, outperforming the MSCI World Index but underperforming the S&P 500 Index.
The ARK Autonomous Technology and Robotics ETF (ARKQ) underperformed broad-based market indexes during the quarter. Among the top detractors were Kratos Defense & Security (KTOS) and UiPath (PATH). Despite several significant contract wins and second-quarter earnings that surpassed top- and bottom-line expectations, shares of Kratos depreciated. Shares of UiPath declined after the company cut revenue guidance for fiscal year 2023. Positively, management made two announcements: a technology integration with Snowflake (SNOW) and an expansion of its partnership with Workday (WDAY).
Among the top contributors to ARKQ’s performance were Velo3D (VLD) and Tesla (TSLA). Shares of Velo3D gapped up after the company reported second-quarter sales that more than doubled year-over-year, driven by a combination of stronger demand in its Sapphire XC system and an increase in its average selling price. SpaceX is Velo3D’s largest customer and a strategic investor. Shares of Tesla appreciated in early July after it announced June sales of its Chinese-produced vehicles that increased 142% sequentially and 135% on a year-over-year basis. During its earnings call, Musk said Tesla aims to produce 40,000 vehicles globally per week by year end. On the other end of the spectrum, Musk pushed its Cybertruck production timeline to mid-2023, citing lengthy delivery backlogs that have forced it into a broad-based pause in new orders.
The ARK Next Generation Internet ETF (ARKW) underperformed broad-based market indexes during the quarter. Among the top detractors were Roku (ROKU) and Zoom Video Communications (ZM). Shares of Roku traded down after the company missed both revenue and earnings estimates for the second quarter. Citing a slowdown in advertising budget growth, management withdrew guidance for full-year revenue, lowering third-quarter growth to 3% on a year-over-year basis. Despite the disappointing quarter and weak guidance, our research indicates that Roku’s long-term growth story remains intact as consumers appear to be adopting CTV (connected TV) and abandoning linear TV. Roku is the #1 streaming platform by hours streamed in the US, Canada, and Mexico. Shares of Zoom fell after the company reported second-quarter earnings that surpassed consensus expectations but missed on revenue. Revenue grew 8% on a year-over-year basis, 200 basis points lower than the 10% consensus expectation based on churn in non-enterprise online customers. Enterprise revenue grew 27% and now represents 54% of total revenue. Total remaining performance obligations (RPO) and current RPO grew 37% and 21% year-over-year, respectively. In our view, the strong growth in RPOs confirms that Zoom’s user base and business model are moving toward longer, higher-value enterprise contracts. Our Zoom investment thesis assumes that the overwhelming majority of Zoom’s business will be in the enterprise by year-end 2026. We maintain high conviction in Zoom’s potential to share with Microsoft a majority of the enterprise communications platform space.
Among the top contributors to ARKW’s performance were Coinbase (COIN) and Tesla (TSLA). Shares of Coinbase rallied following news that BlackRock’s Aladdin has partnered with Coinbase Prime to offer direct bitcoin exposure for its US institutional clients. Coinbase will help BlackRock facilitate crypto trading, custody, prime brokerage, and reporting capabilities. In our view, BlackRock’s decision to partner with Coinbase is a strong signal that institutions consider crypto––starting with bitcoin––a new asset class. ARK maintains conviction in blockchain technology’s ability to disrupt traditional business models, especially in financial services. Shares of Tesla also contributed to performance, for reasons discussed above.
The ARK Genomic Revolution ETF (ARKG) outperformed broad-based market indexes during the quarter. Among the top contributors were Signify Health (SGFY) and 1Life Healthcare (ONEM), also known as One Medical. Shares of Signify jumped following news that CVS is acquiring the company. The acquisition follows Amazon’s recent acquisition of One Medical, suggesting an emerging pattern of consolidation in the digital healthcare space. Signify Health seeks to activate the home as central to healthcare, enabling its members to avoid inefficient and unnecessary medical costs. Shares of 1Life Healthcare (One Medical) gapped up after the company announced that Amazon would purchase it for $3.9 billion. 1Life Healthcare provides a membership-based, primary care platform with seamless digital health and in-office care.
Among the top detractors from ARKG’s performance were Exact Sciences (EXAS) and Teladoc Health (TDOC). Shares of Exact Sciences fell in August after the company posted strong second-quarter results but lowered full-year guidance. Given its breadth of oncology offerings, we believe Exact will lead in the early disease detection space. Shares of Teladoc fell after the company reported mixed second-quarter financial results. Most of the company’s key operating metrics in the quarter affirmed our long-term thesis that Teladoc could become a premier enterprise partner for hybrid care delivery in the US and elsewhere. Both utilization and per-member-per-month (PMPM) spending reached all-time highs of 24% and $2.60, respectively. PMPM increased 13% year-over-year from $2.31, while new member additions and chronic care enrollment surpassed analysts’ expectations. Consumer sentiment, discretionary spending, and paid search yields do seem to have impacted Teladoc’s EBITDA[11] margin but, in our view, those forces are transient, certainly in the context of ARK’s five-year investment time horizon.
The ARK Fintech Innovation ETF (ARKF) outperformed broad-based market indexes during the quarter. Among the top contributors were Coinbase (COIN), for reasons discussed above, and MercadoLibre (MELI). Shares of MercadoLibre rallied after the company reported second-quarter earnings, including a 57% increase in local currency revenue on a year-over-year basis. Although total revenue growth decelerated, local currency growth in Mexico reaccelerated from 59% in the first quarter to 66%. Commerce and fintech revenue grew 23% and 107% year-over-year, respectively. While mindful of the economic weakness in most emerging markets, we believe that MercadoLibre has the potential to become the dominant e-commerce and fintech platform in Latin America.
Among the top detractors from ARKF’s performance were UiPath (PATH), for reasons discussed above, and Discovery (DSY SJ). Shares of South Africa’s Discovery traded down as part of a broad market rotation out of emerging markets stocks during the third quarter. Discovery offers global market-leading “wellness-oriented” insurance products based on behavioral science and artificial intelligence.
The ARK Space Exploration & Innovation ETF (ARKX) underperformed broad-based market indexes during the quarter. Among the top detractors were Kratos Defense & Security (KTOS), for reasons discussed above, and Alphabet (GOOG). Shares of Alphabet declined following the European Union General Court’s decision to uphold an antitrust ruling against the company. South Korean regulators also fined the company for violating privacy laws.
Among the top contributors to ARKX’s performance were Velo3D (VLD), for reasons discussed above, and Iridium Communications (IRDM). Shares of Iridium rallied after the company reported record second-quarter earnings and raised full-year guidance, propelled by new subscriber activations and increased demand for equipment. During the quarter, Iridium also announced an agreement with SpaceX to launch up to five of its remaining ground satellites.
With some of the highest conviction names from the Funds discussed above, the ARK Innovation ETF (ARKK) performance during the quarter was mixed relative to broad-based indexes, outperforming the MSCI World Index but underperforming the S&P 500 Index. Among the top detractors were Zoom Video Communications (ZM) and Roku (ROKU), for reasons discussed above.
Among the top contributors to ARKK’s performance were Signify Health (SGFY) and Tesla (TSLA), for reasons discussed above.
ARK’s self-indexed ETFs, The 3D Printing ETF (PRNT) and ARK Israel Innovation Technology ETF (IZRL), depreciated and underperformed broad-based indexes, though PRNT did outperform the MSCI World Index.[12] Shares of BICO Group (BICO SS), a producer of bioinks and bioprinters, were the largest detractor from PRNT’s performance. Management reported lower customer instrumentation revenues in the face of lockdowns and global supply-chain disruptions in China. Shares of SLM Solutions Group (AM3D GR) were the largest contributor to PRNT. Japanese camera maker Nikon Corp announced plans to acquire the company, highlighting the increasing importance of metal additive manufacturing. Shares of Compugen (CGEN) were the largest detractor from IZRL’s performance despite an announcement that the European Patent Office granted the company a new patent covering anti-PVRIG[13] antibodies for cancer treatment. Shares of Inmode (INMD), a producer of minimally invasive aesthetic medical products, were the largest contributor to IZRL’s performance, rallying after second-quarter earnings surpassed expectations thanks to a 30% increase in year-over-year revenue growth.
The ARK Transparency ETF (CTRU) was an indexed exchange-traded fund aligned with the performance of the Transparency IndexTM (TRANSPCY) and designed to track the stock price movements of the 100 most transparent companies in the world. Based on the index’s discontinuation, we closed the Fund on July 26, 2022.
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