“…certainly with valuations where they are, I’m sure we’re going to go through a doozy of a correction this year. At some point. I don’t know when. And I don’t know why. But I do know, it never hurts to take profits and to keep some powder dry so that you have the psychological wherewithal when the world seems to be falling apart to pick up on bargain basement prices…”
Cathie Wood, January 8, 2021, “In the Know with Cathie Wood, Episode XI“
That date is not a typo. Cathie Wood, the prominent leader of ARK Investment Management LLC, sat on top of tremendous profits in her flagship ARK Innovation ETF (ARKK) on January 8, 2021. Her caution proved prescient, but it could not save her funds from the coming “doozy of a correction.” Just over a year later, Wood has navigated her funds through a severe bear market including at least two steep corrections. After a stellar 149% gain in 2020, ARKK lost 24% in 2021. This decline included a 40% collapse from the all-time high. ARKK is already down another 19% in 2022 after just over two weeks of trading.
This pullback could represent an opportunity to buy innovation strategies at “de-risked” levels. I reviewed Wood’s commentary at key junctures for her funds and the market to get some clues. I decided to hold for now.
Cathie Wood is remarkably, perhaps even stubbornly, consistent in her concentrated, thematic approach. Since the companies have not changed, her long-term assessments also remain the same. Wood’s nemesis is a stock market refusing to pay up for risk. Accordingly, I realized that the technicals of the market are likely sufficient as a strategy for determining entry points. Indeed, I am still using ARKK puts as a partial hedge against on-going market selling.
Still, Wood’s periodic reassurances and defenses provide key lessons for managing concentrated, thematic investing. The approach is fantastic when the market buys the story. However, it can be extremely challenging when the tide turns against the narrative. With the payoff and profits from marvels like robotic taxis, digital wallets and personalized medicine years off in the future, the value in innovation strategies is particularly sensitive to the whims of market sentiment. These strategies were boosted by easy money policies. It is not yet clear whether and how these strategies will return to favor during a period of monetary tightening. Without the flexibility to respond to the changing tides, the concentrated innovation strategy must then suffer through tremendous volatility on the way to the future. In other words, Wood’s advice a year ago to take profits was a signature lesson from my review.
Juncture January 8, 2021
At the beginning of 2021, the ARK funds were still enjoying the pandemic-driven uptrend. Cathie Wood observed that the bull market was broadening out with cyclicals joining the party. However, she recognized that the Fed would need to reconsider its easy money policies with the economy continuing to strengthen. She even looked forward to a Fed withdrawal because the market could then “do its work.” Wood acknowledged that a change in policy would cause “bumps in the market.” The market’s work of course evolved from bumpy to outright turbulent.
While taking profits looked warranted under these circumstances, Wood still mused about the possibility that proactive, inflation-wary investors would get rid of dollars by moving even more into the asset markets. If so, inflationary pressures in the real economy would subside. I take great interest in this theory because I often wonder whether the previous deflationary period was supported by a stock market absorbing a lot of the cash that could have gone to massive consumption.
Anyway, this market juncture proved to be exceptionally important. The inability to get ahead of a correction meant that the ARK ETFs would inevitably have to suffer along with the stock market. However, Wood did not (and could not) anticipate the severity of the coming negative divergence between ARK and the rest of the stock market.
Juncture February 17, 2021
Ark made its last all-time high two trading days before Cathie Wood participated in a key interview with CNBC. The interviewers clearly sensed that the market was over-stretched, and they wanted to understand how Wood would deal with the growing headwinds. At the same time, I wrote about the potentially negative implications of overbought conditions.
Wood was characteristically on message. For example, Wood declared that “we want our companies to invest aggressively. We don’t want profits now.” She was even consistent with the caution she issued in January. This time, Wood sounded ready to act on a sell-off. Paraphrasing her comments:
“I do believe that if rates take a sharp turn up, we would see a valuation reset. And our portfolios would be prime candidates for that valuation reset…There will be a valuation reset. There will be fear. And we will use it to our benefit, concentrating our portfolio to our highest conviction names.”
This tax efficient strategy of concentrating a portfolio into a sell-off is interesting. If enough people follow the same strategy, then the weakest stocks in a sell-off are the first to fall and are doomed to fare the worst. When the most loved stocks finally fall, the money and enthusiasm must truly be at an end. In oversold markets, this fall should be the beginning of the end of the selling. Those castaway stocks should next form the core of capitulation in a down cycle for innovation strategies. I hope to identify the diamonds in the trash bin in the future.
Wood disclosed that over the prior 6 months, the portfolio expanded with the bull market. ARKK expanded from 33 stocks in the pandemic-driven stock market collapse to 52 stocks at the time of the CNBC interview. At the time of writing, ARKK holds 43 stocks. ARKK could get yet more concentrated if the innovation bear market deepens further.
SPAC Toppings
I was very surprised to hear the extent of Cathie Wood’s speculation when it comes to SPACs. Wood listed investments in Draft Kings (DKNG), Butterfly Network Inc (BFLY), Skillz (SKLZ), and Blade Air Mobility (BLDE). All but DKNG happened to top out right around the time of this interview. Using SwingTradeBot I identified the ARK ownership of these SPACs (note the amount of overlap):
- DKNG: ARKK, ARK Next Generation Internet ETF (ARKW), and ARK Fintech Innovation ETF (ARKF). DKNG is already down another 22.1% this year and headed toward a complete reversal of its pandemic gains.
- BLDE: ARK Space Exploration & Innovation ETF (ARKX) and ARK Autonomous Technology & Robotics ETF (ARKQ) have the largest allocations by far of the few ETFs holding BLDE. BLDE is already down another 29.7% this year.
- BFLY: ARK Genomic Revolution ETF (ARKG). BFLY is “only” down 4.5% this year but has crashed 76% from its all-time high set the day after this CNBC interview.
- SKLZ: ARKK (I also got caught speculating in SKLZ).
These kind of losses suggest traders might be trying to front-run ARK trimming.
Juncture February 26, 2021
By this time, a sharp pullback was underway. Cathie Wood welcomed it as a reality check on speculation in the innovation space. She declared that she liked the fear and insisted it would not last. She could not know at the time, but the market was in the process of delivering lasting markdowns well ahead of the Fed’s coming hawkishness. Wood thought the market would lead the Fed to terminating QE. However, Fed Chair Jerome Powell persisted for months in reassuring everyone that inflation was transitory. With inflation measures stubbornly moving higher and higher, the Fed finally had to respond to the political pressures that come from increasing inflation numbers.
Wood also welcomed the rally in cyclical stocks which benefited from bets on inflationary pressures. Yet the broadening Wood welcomed was actually topping out per my favorite technical indicator, AT50 (MMFI), the percentage of stocks trading above their respective 50-day moving averages (DMAs).
With inflation fears increasing, Wood turned to her deflationary narrative as a contrarian claim. She calculated that the economy will grow its way out of inflationary pressures. Innovation cost curves over time will drive deflationary forces. Companies of the “old world order” will be put at risk. These companies have leveraged up to buy back stock and pay dividends to short-sighted investors. They will be forced to cut prices to increase sales to get the cash for servicing debt. This narrative undergirds Wood’s on-going skepticism about the sustainability of inflationary pressures. I agree that inflation will wane but because the Fed is finally getting serious about it.
Juncture May 7, 2021
At this time, the S&P 500 (SPY) was just coming off its latest all-time high. Meanwhile, ARKK and its ilk were taking a fresh leg down to new lows for the year. The stark divergence in market performance compelled Wood to note certain (innovation) strategies just suffered a full market cycle in just 4 months. She could not know it at the time, but the subsequent rally and stabilization was just a 6-month setup for the resumption of the bear market for innovation strategies. The stock market was no longer broadening: cyclicals and value stocks were doing fine while innovation stocks just kept dropping. AT50 warned anyone watching that the market was actually narrowing, not broadening. AT200 (MMTH), the percentage of stocks trading above their respective 200DMAs, sent an even clearer message about a narrowing stock market. Innovation stocks simply received less and less room for attention.
Wood zeroed in on a proposal to increase capital gains taxes as a catalyst for slamming high flyer stocks. This explanation turned out to be a red herring, especially since the major indices continued floating higher. Still, to her credit, Wood once again acknowledged that innovation strategies will underperform during a rotation to value. Of course, she scoffed at the rally in value as being misguided toward companies that would suffer from future deflation. Wood relished what she described as her contrarian view on inflation. She sees innovation driving cost curves down, creative destruction taking out whole companies (which could actually be inflationary if market power becomes more concentrated), and duplicate ordering from the on-going supply chain disruptions.
Wood concluded that she looked forward to innovation joining the party again. Unfortunately, the Federal Reserve had other plans. The Fed first talked about taking away the punchbowl, then it actually started to do so.
Juncture January 7, 2022
Now fast-forward to this year. ARKK lost 10.8% in just the first week of trading. With ARKK entering crash territory with a 46.1% loss from its all-time high, Cathie Wood aggressively went on the offensive. She directly attacked value stocks which she claimed trade in a valuation bubble. She singled out Ford Motor Company (F) which gained 17.7% in just the first week of trading for the year. Moreover, Ford delivered innovation type gains of 136% in 2021….and the stock is still not yet back to the all-time high it set in early 1999.
Because she expects focused electric vehicle companies to destroy Ford’s earnings, Wood does not care that F only trades at 10x forward earnings. On the other hand, Zoom Video Technology (ZM) is a value stock trading 33-35x forward earnings. I covered this discussion in more detail in Stock Chart Reviews: Snapshots of A Disappointing Start to the New Year.
This episode was also remarkable in the amount of time Wood spent explaining the deflationary thesis. Her critique of the inflation narrative turned to China. In China, Wood sees a brewing debt implosion that will hobble the Chinese economy. This calamity will in turn unleash deflationary forces on the global economy. I was surprised she spent no time pondering how such a dramatic event could also cause risk aversion to soar and accelerate valuation compression in innovation stocks. Such a calamity could redefine “a doozy of a correction” for the worse!
The Cathie Wood Trade
Because the ARK funds are all closely correlated, there is little need to invest or trade in more than one. I prefer to keep the closest eye on ARKK as the most diversified of the bunch. As long as momentum is working against premium valuations, I will treat ARKK as a hedge against the stock market as a whole. I expect the technicals to provide a sufficient signal of seller exhaustion. Of course, during oversold trading conditions, ARKK will be one of the first ETFs I will look to buy for at least a relief rally. The narrative is simple: as long as the Fed is in tightening mode, I am unlikely to invest in the ARK funds – technicals notwithstanding.
A more conventional approach to investing in a rising rate environment
Finally, review the video below for a more conventional discussion of how interest rates impact a dynamic investment cycle. The couple featured in the video below promote the early retirement lifestyle. Note the distinct contrast in the conventional approach to the viewpoint from the innovation strategy. Conventional portfolio management adjusts. The innovation strategy finds little need to adjust because deflation is a secular, long-term trend.
Be careful out there!
Full disclosure: long ARKK put option, long SKLZ