During the fourth quarter, broad-based global equity indexes – as measured by the S&P 500 and MSCI World – appreciated, even though the Omicron variant of the coronavirus and inflation fears damaged consumer confidence. As measured by the University of Michigan, by October 31, 2021, consumer sentiment had dropped to a level last seen during the depths of the coronavirus crisis in 2020. Beneath the surface of broad-based indexes, performance was mixed, if not ominous. According to The Leuthold Group, a record number of companies trading on both the NYSE and the NASDAQ hit new lows in 2021, roughly 334 and 700 respectively, even though the S&P 500 and NASDAQ indexes were approaching all-time highs. The number of 52-week new lows on the NYSE was more than double the new highs as the S&P 500 index hit all-time highs, a juxtaposition that has occurred only three times in the last 60 years, all three times in December 1999 at the peak of the tech and telecom bubble.
While fears of inflation hit stocks with high valuations based on current earnings, other markets do not seem to be discounting the same fears. Chief among reasons for the current rotation from growth stocks toward “value” and defensive stocks, including FAANGs, is the view that inflation is not a short-term problem related to supply chain bottlenecks but, instead, the result of excessive monetary and fiscal policy responses to the coronavirus and its variants. Other markets, however, are not corroborating that scenario. Broad-based public market index valuations are near levels not seen since the tech and telecom bubble. In the early eighties, as inflation ravaged the US economy, the S&P 500 price-earnings (PE) ratio collapsed to a low of 6.8x, roughly a quarter of today’s valuation. Likewise, private equity market valuations of innovative companies are near record highs while comparable public company valuations have tanked. Finally, the bond market seems to be warning the Fed not to tighten. Since February, the yield curve––as measured by the difference between the yields on the 10-year Treasury bond and the 2-year Treasury note––has flattened from 159 basis points to 79 basis points, pointing to the rising probability of recession, lower inflation, or both during the next year.
In our view, long-term inflation fears are overblown because inventories are stacking up in the face of weak consumption. In November, retail inventories rose more than 2%, the fastest pace since the 1990’s, while imports jumped 4.7% and exports dropped 2.0%. Moreover, real consumption (including services) was flat, and the savings rate dropped to 6.9%, below the pre-coronavirus crisis level, leaving less room for future consumption and hoarding. These percent changes are not annualized, so multiply them by twelve to understand the drama unfolding in the US. Both businesses and consumers seem to have overreacted to supply chain bottlenecks by building “inventories” of goods while government stimulus was flowing freely. Adding to the downward cyclical pressures that are brewing, the Chinese economy has been slowing in response to the government crackdown on real estate, social media, and other sectors and is beginning to put downward pressure on commodity prices.
In the short term, inventory hoarding and other factors has pushed US headline consumer price inflation to 6.8% on a year-over-year basis, a rate that we believe deflationary forces – good, bad, and cyclical – are likely to unwind during the next year. Innovation is the source of good deflation, as learning curves cut costs and increase productivity. In contrast, catering to short-term oriented, risk-averse shareholders who have demanded profits/dividends “now,” many companies have leveraged their balance sheets to buy back stock, bolster earnings, and increase dividends, curtailing investment in innovation. As a result, with aging products and services, they could be facing disintermediation and disruption and could be forced to cut prices to clear inventories and service their bloated debts, causing “bad” deflation.
If we are correct, during the next three to six months the market is likely to focus more on the risk of recession in the US, the serious slowdown in the Chinese and emerging market economies, and potentially a surprising drop in inflation. Some commodity prices already are flashing red: iron prices have dropped 35%, perhaps in response to the real estate turmoil in China, while the Baltic Freight Dry Index has declined more than 40%, DRAM prices 25%, and US lumber prices 33%. Even the WTI oil price, a notable outlier until recently, has declined by 12%. Typically, during a slowdown, the adoption of new technologies accelerates as concerned businesses and consumers are more willing to change behavior patterns. In our view, after a significant correction in innovation-related stocks during the past year, many of the technology leaders to which they will turn now seem to be in deep value territory in the context of a five-year investment time horizon.
If we are correct in our assessment that the risk to the outlook is deflation, not inflation, then nominal GDP growth is likely to be much lower than expected, suggesting that scarce double-digit growth opportunities will be rewarded accordingly. Growth stocks in general and innovation-driven stocks specifically could be the prime beneficiaries. The onset of the pandemic and subsequent variants generated broad based fear, uncertainty, and doubt (FUD) in the equity markets, causing what we believe to be indiscriminate, algorithmic selling as a form of short-term risk management. Typically, FUD accelerates the adoption of new technologies as concerned businesses and consumers change their behaviors much more rapidly and, before the end of a correction or bear market, new leadership emerges in the equity market. In our view, the coronavirus crisis transformed the world significantly and permanently, suggesting that many innovation-driven stocks could be productive holdings during the next five to ten years.
Focused primarily on inflation these days, the equity markets seem to be ignoring the significant headwinds facing traditional industries. The automotive industry is a prime case in point. In the US, new car sales peaked last April at a seasonally adjusted annual rate (saar) of 18.25 million units and dropped throughout the year. Initially blaming the semiconductor shortage, auto executives communicated during earnings season in October that supply chain bottlenecks were beginning to clear. Nonetheless, sales continued to fall from 13 million in October to 12.9 million and 12.4 million in November and December, respectively. Moreover, as measured by the Manheim Group, the average days supply of used car inventories at the wholesale level in December in the US was 33 days, 40%+ higher than the typical 23 days. Meanwhile, electric vehicle (EV) sales nearly doubled in 2021. As measured by the University of Michigan, in October 2021 consumer sentiment dropped back to levels last seen during the depths of the coronavirus crisis in 2020 and remained low through the rest of the fourth quarter and we believe is is depressing the sale of big-ticket items at the same time that consumer preferences are shifting to electric vehicles. Despite this backdrop, the equity prices of legacy original equipment manufacturers (OEMs) have surged during the past year on news of their EV investments, even though EVs account for only 2-3% of their revenues. With 97-98% of their revenue base exposed to gas-powered cars with gross margins in the 10-20% range, we believe OEMs do not have much room for error and could suffer major losses during the accelerated transition to EVs. In our view, the real bubble could be building in such so-called “value” stocks with much higher valuations in the context of a five-year investment time horizon as opposed to last year. Meanwhile, the valuations of many innovation-related stocks have been cut in half.
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.
Relative to the S&P 500 and the MSCI World Index, ARK’s six actively managed ETFs and three self-indexed ETFs underperformed during the fourth quarter.
To read a summary of ARK’s biggest contributors and detractors, please see below.
The ARK Autonomous Technology and Robotics ETF (ARKQ) underperformed the broad-based market indexes during the quarter. Among the top detractors were UiPath (PATH) and Kratos Defense & Security (KTOS). PATH was impacted negatively by the broader SaaS stock selloff and concerns about the competitive landscape. Our research suggests that artificial intelligence (AI) could increase the productivity of knowledge workers by 2.4-fold on average by 2030, driving $14 trillion in potential annual AI software spend. We believe UiPath is well-positioned to benefit from this trend, given its early success, unique data assets, and technology advantages. We are not presently concerned by the competitive landscape and believe its evolving support for unstructured data will strengthen UiPath’s competitive positioning. KTOS traded down despite announcing a number of new contracts, one worth $17 million from the US Air Force to develop an Off Board Sensing Station (OBSS) Unmanned Aerial System (UAS) and another $4.1 million for unmanned aerial target drone system aircraft.
Among the top contributors were Tesla (TSLA) and Unity Software (U). TSLA appreciated after the company reported upside surprises in third-quarter sales and earnings. Hertz also announced that it had ordered 100,000 Tesla vehicles. U appreciated after the company beat third-quarter revenue and earnings expectations and raised full-year revenue guidance. The company unveiled Unity Metacast, an innovative new platform focused on the real-time 3D evolution of professional sports. The UFC, a leading mixed martial arts organization, will collaborate on researching and developing potential applications. Additionally, Unity acquired Weta Digital which could help Unity’s expansion into high-performance game development with a hyper-realistic game engine that should compete effectively against Epic Games’ Unreal Engine.
The ARK Next Generation Internet ETF (ARKW) underperformed the broad-based market indexes during the quarter. Among the top detractors were DraftKings (DKNG) and Twitter (TWTR). While DraftKings missed third-quarter revenue expectations, ARK is gaining conviction that its platform will pull away from the competition given the convergence of sports betting, iGaming, and NFTs. Twitter’s US user growth decelerated in the third quarter, raising concerns about market saturation. ARK believes the transition of Twitter’s user base from teens and celebrities to knowledge workers is continuing, expanding the market opportunity. Adding to investor concerns, Jack Dorsey handed the CEO reins to Parag Agrawal, who joined Twitter roughly 10 years ago as a software engineer and is likely to focus more on monetizing the platform. That said, we will monitor the platform’s censorship which could provoke users into defecting.
Among the top contributors were Tesla (TSLA) and Unity Software (U), for reasons discussed above.
The ARK Genomic Revolution ETF (ARKG) underperformed the broad-based market indexes during the quarter. Among the top detractors were Teladoc Health (TDOC) and Exact Sciences (EXAS). TDOC was punished by the “stay-at-home” stock selloff. ARK believes the market is missing the competitive differentiators that transcend Teledoc’s role as a dominant telemedicine provider. Teladoc’s talent in the data science/Airtifical Intelligence (AI)/Machine Learning (ML) field has enhanced its data quality and volume, so much so that we believe its data-generated insights are becoming best in class. Connecting hospitals, doctors, patients, and insurance companies, Teledoc could become the US healthcare industry’s data backbone. Exact Sciences posted a mixed third quarter, beating revenue guidance but missing earnings expectations. Analysts seemed transfixed not only on the COVID-driven Cologuard revenue slowdown but also the EPS dilution following a wave of acquisitions. ARK believes the company is in a solid position with a meaningful lead in molecular prognostics and single/multi-cancer screening.
Among the top contributors were Vertex Pharmaceuticals (VRTX) and Codexis (CDXS). VRTX rallied on positive results from a Phase 2 proof-of-concept study focused on mid-stage focal glomerular sclerosis. In the study, patients tolerated VX-147 well with statistically significant results. CDXS rallied after positive data on Merck’s COVID-19 pill for which it supplies the enzyme. The stock also responded positively when Pfizer purchased roughly $29 million of its COVID-19 antiviral candidate which boosted third quarter revenues and earnings above expectations.
The ARK Fintech Innovation ETF (ARKF) underperformed the broad-based market indexes during the quarter. Among the top detractors were Block (SQ) and Robinhood Markets (HOOD). In December, Square changed its name to Block, signaling its increased focus on blockchain payment solutions. That said, the market reacted negatively to Block’s third-quarter earnings report, not only to the slowdown in Cash App growth to levels last seen prior to the boost from government stimulus checks but also to lower than expected bitcoin trading revenue. HOOD dropped below its IPO price as investors worried about the impact of lower trade volume and the potential regulation of payment for order flow. In ARK’s view, Robinhood could evolve into one of the more influential digital wallets given its strong product suite, brand, and network effects.
Among the top contributors were Silvergate Capital (SI) and Coinbase Global (COIN). SI appreciated in tandem with the broader crypto market. Founded as a traditional commercial bank in the late eighties, today Silvergate is focused primarily on services that enable institutions to access cryptocurrencies. In November, Morgan Stanley published a report analyzing the increasing correlation between Silvergate’s stock and the price of bitcoin as institutional investors increase their allocations to cryptoassets. COIN appreciated following announcements to broaden its crypto-focused product suite. The company announced plans to launch a peer-to-peer non-fungible token (NFT) marketplace, which we believe will help diversify its revenue stream from brokerage and custody services into NFTs. Additionally, the recent direct deposit feature may reduce the friction associated with converting fiat currencies into cryptoassets, enabling decentralized finance (DeFi) and NFT applications on Coinbase.
The ARK Space Exploration & Innovation ETF (ARKX) underperformed the broad-based market indexes during the quarter. Among the top detractors were AeroVironment (AVAV) and JD Logistics (2618 HK). Shares of AeroVironment, a leader in small and medium unmanned aerial systems for military use, fell sharply after management reduced 2022 guidance, citing delays associated with supply chain bottlenecks and government decision-making. Pressure on Chinese stocks, fear of the Omicron variant of the coronavirus, and congested supply-chains weighed on shares of JD Logistics. In our view, JD Logistics could benefit as China aims to accelerate the pace of autonomous technology, experimenting with drones and last-mile delivery vehicles.
Among the top contributors were Unity Software (U) and Teradyne (TER). U contributed to performance for reasons discussed above. TER rallied following the company’s third-quarter earnings report which surpassed expectations on the top- and bottom-lines with gross margin expansion, marking the eighth consecutive quarter of double-digit revenue and profit growth on a year-over-year basis. Notably, year-over-year growth for Teradyne’s Industrial Automation Unit was 32%, with Universal Robots growing 46%.
With some of the highest conviction names from the Funds discussed above, the ARK Innovation ETF (ARKK) underperformed the broad-based indexes during the quarter. Among the top detractors were Teladoc Health (TDOC) and Zoom Video Communications (ZM). TDOC detracted from performance for reasons discussed above. The “stay at home” selloff also impacted ZM negatively. Given the critical nature and frequent use of communications tools, many organizations seem willing to pay a premium for superior solutions. Because it has invested aggressively in unified enterprise communications infrastructure, we believe Zoom is delivering superior audio and video performance compared to its competitors and has expanded beyond video conferencing with Phone and Rooms. According to our research, early adoption of these adjacent products is promising, suggesting that Zoom is well-positioned to disrupt the nearly $1.5 trillion enterprise communications market. Among the top contributors were Tesla (TSLA) and Unity Software (U), for reasons discussed above.
ARK’s self-indexed ETFs, The 3D Printing ETF (PRNT) and the ARK Israel Innovation Technology ETF (IZRL), depreciated and underperformed both their defined indexes and the broad-based indexes during the quarter. Desktop Metal (DM) was the largest detractor from PRNT’s performance as investors grew concerned after larger than expected losses in the third quarter and guidance for the fourth quarter that fell below expectations. HP Inc (HPQ) was a top contributor to performance after reporting better than expected revenue and increasing its dividend.
IceCure Medical (ICCM) was the largest detractor from performance in IZRL as biotech sold off broadly. IceCure develops and markets minimally invasive cryoablation therapies to address women’s health issues. Partner Communication (PTNR), a mobile network operator in Israel, was the top contributor, responding positively to third-quarter revenue growth across business segments.
The ARK Transparency ETF (CTRU) launched on December 8th, 2021. This index ETF seeks to provide investment results that closely correspond, before fees and expenses, to the Transparency IndexTM (TRANSPCY), which is designed to track the stock price movements of the 100 most transparent companies in the world.
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