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Broad-based global equity indexes[1] depreciated significantly during the second quarter as global recession fears boiled to a tipping point, damaging consumer, business, and investor confidence. Innovation stocks, particularly those outside the broad-based indexes, were particularly hard hit during the first half of the quarter before succumbing to significant weekly price swings during the second half.
Between March 2021 and the end of the second quarter 2022, the yield curve[2] flattened from 159 basis points to 6 basis points with brief inversions, 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[3] plummeted to 50––a historic low that undercut levels seen during the coronavirus pandemic, the 2008-2009 Global Financial Crisis, and the early 1980s when the economy suffered two recessions and inflation and interest rates hit double digits.
The odds of a global recession increased meaningfully in March after Russia’s invasion of Ukraine. Although inflationary in the short-term, the rise in oil prices has imposed a highly regressive tax on consumers. Dependent on Russia for energy, Europe seems to have entered recession. China seems to have erred on the side of restraint and is trying to resuscitate growth and, in the US, the Atlanta Fed’s GDPNow is forecasting a second sequential decline in real GDP––a recession—in the US.
In our view, long-term inflation fears have been misplaced because the gold price is trading at the low end of a two-year range, copper prices have broken down from a one-year range, and global inventories have piled up. Meanwhile, the US consumer savings rate has dropped to 5.4%[4], roughly 250 basis points below its level prior to the coronavirus crisis which, when coupled with historically low consumer sentiment, suggests less room – if any – for growth in consumption. During the past year, in an overreaction to bottlenecks in the supply of goods and services, businesses and consumers appear to have accumulated “inventories”. In their first-quarter earnings releases, Walmart and Target––two companies that have perfected supply chain management––reported that inventories increased 32% and 43% in nominal terms on a year-over-year basis, which likely translated into 20-25% and 30-35% in real terms, respectively. Meanwhile, for the first time since its launch in October 2020, the price of Nvidia’s RTX 3070 GPU has dropped more than 65% to the MSRP (manufacturer’s suggested resale price), and it was reported that customers of Taiwan Semiconductor are pulling semiconductor orders in response to excess inventory. In our view, in an attempt to satisfy stronger than expected demand, companies double- and triple-ordered goods, creating an inventory glut that will unwind as companies lower prices to clear their shelves. Unsurprisingly, the Institute for Supply Management (ISM) reported the first contraction in new orders since mid-2020[5]. The combination of geopolitical forces and inventory hoarding has pushed US consumer price inflation––a lagging indicator of inflation––to 9.1%[5] on a year-over-year basis, a rate that we believe deflationary forces––good, bad, and cyclical––are beginning to unwind.
Excessive inventory levels are not the only cyclical signal flashing deflation. Credit default swaps (CDS)––insurance policies against bankruptcies––have doubled this year[6], surpassing their peaks during the market rout in late 2018, and are heading back toward COVID crisis levels. The US Dollar has strengthened 9.4% this year and more than 14.0% from its lows last year, placing a significant burden on emerging and other markets with dollar-denominated debt. Priced in dollars, commodities also have been suffering. After soaring to a peak of roughly $2,060 per ounce during 2020, the price of gold has dropped roughly 16% back to $1726[7], the low end of its trading range during the last two years, while the price of copper has broken significantly below $4.00 per pound, the low end of a one-year $4-5 range. Interestingly, electric vehicles––the beneficiary of a consumer preference shift as energy prices soar––require 3-5x more copper than internal combustion engines, suggesting that copper’s breakdown is even more meaningful. Finally, while the oil cartel and the Russia-Ukraine war have pushed it to levels on the high end of expectations, the oil price declined to the lower end of the trading range in place since Russia invaded Ukraine. In our view, Energy––the strongest-performing sector since the rotation to cyclicals began in February 2021––will be disrupted and disintermediated by autonomous electric vehicles during the next five years, leaving many in the crowded “long oil and commodities” trade[8] on the wrong side of innovation.
Innovation is the source of good deflation because learning curves cut costs and increase productivity. In our view, many companies have catered to the short-term-oriented, risk-averse shareholders, satisfying demands for profits/dividends “now”. As a result, many have leveraged their balance sheets to buy back stock, bolster earnings, and increase dividends. In so doing, they have curtailed investments in innovation and could be ill-prepared for the disintermediation associated with disruptive innovation. Saddled with aging products and services, they could be forced to cut prices, service debt, and clear unwanted inventories, causing bad deflation.
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 should be rewarded accordingly. The adoption of new technologies typically accelerates as concerned businesses and consumers change their behavior much more rapidly than otherwise would be the case, giving new leadership an opportunity to surface in the equity 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 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 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 invest aggressively at the expense of short-term profits. For years, as many investors assumed that it would go bankrupt, Amazon invested in an effort to disrupt legacy brick and mortar businesses, capturing a disproportionate share of the retail e-commerce opportunity. In early days, Wall Street also missed the potential of Apple’s iPhone to disrupt Nokia, Samsung, 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 doomed to failure: they did not understand that Tesla was a robotics, energy storage, and artificial intelligence company, not an auto company. Controversial and volatile in the short-term, companies focused on innovation that solves problems and disrupts legacy industries can surprise on the upside with significant exponential growth trajectories. In our view, active management will play a crucial role as many disruptive companies will compete in winner-take-most markets.
During the second quarter of 2022, ARK’s six actively managed ETFs and three indexed ETFs underperformed relative to the S&P 500 Index and the MSCI World Index.
The ARK Autonomous Technology and Robotics ETF (ARKQ) underperformed broad-based market indexes during the quarter. Tesla (TSLA) and Velo3D (VLD) were the top detractors. Despite a strong first-quarter earnings report that featured record deliveries and operating margins, shares of Tesla were under pressure as sell-side analysts cut delivery estimates, citing macro headwinds and supply chain problems including the Shanghai shutdown. In our view, these fears were short-sighted and overblown. Additionally, investors were concerned that Musk’s proposed acquisition of Twitter would prove a distraction. Disagreeing with the conventional wisdom, we were encouraged by Tesla’s plans to produce a steering-wheel-less and pedal-less robotaxi vehicle in 2024, its strongest commitment to robotaxi commercialization to date. Shares of Velo3D fell sharply in April following an SEC filing disclosing potential supply-chain delays in the shipment of two of its printer models. Despite a first-quarter earnings report highlighting increased demand for its products, a record backlog, and investments from companies like SpaceX, Velo3D’s shares succumbed to a broader based sell-off in innovation stocks.
Among the top contributors to ARKQ’s performance were BYD (BYDDY) and Xpeng (XPEV). Despite headwinds from COVID’s impact on the Chinese auto industry, EV manufacturer BYD reported impressive results for first-quarter net income and vehicle sales. Defying COVID-related obstacles, the company announced a 270% increase in April deliveries and an agreement to supply batteries to Tesla. Shares of Chinese Electric vehicle maker Xpeng rallied after it hit a milestone of 200,000 cumulative units delivered and Shanghai announced stimulus measures.
The ARK Next Generation Internet ETF (ARKW) underperformed broad-based market indexes during the quarter. Among the top detractors were Coinbase Global (COIN) and the Grayscale Bitcoin Trust (GBTC). Shares of Coinbase depreciated following lower than expected first-quarter earnings and the Terra ecosystem collapse. As first-quarter results fell short of analysts’ expectations, the company unveiled plans to forgo short-term profitability and increase investments. Coinbase also faced internal challenges, including layoffs and less-than-expected traction in its NFT marketplace. Despite the headwinds, Coinbase provided several updates to its crypto payment offering, Coinbase Commerce, and launched several new products including its first derivatives product, Nano Bitcoin Futures, and Solana staking. In our view, Coinbase is the premier, regulatory-compliant crypto platform with major competitive advantages in an industry as it consolidates. Shares of Grayscale Bitcoin Trust, a digital-native asset manager that tracks bitcoin’s market price, depreciated significantly, hurt by its perception as a risk-on asset––as opposed to an inflation hedge––as the Fed increased interest rates. As the Terra ecosystem collapsed in May, contagion spread to major crypto lenders, including Blockfi, Celsius, Babel, Voyager, and CoinFlex, contributing to the insolvency of the once highly respected hedge fund, Three Arrows Capital. GBTC premium relative to NAV dropped to -31% as the SEC denied Grayscale a spot bitcoin ETF approval.
Among the top contributors to ARKW’s performance were Twitter (TWTR) and Vuzix (VUZI). Shares of Twitter appreciated after Elon Musk disclosed a significant stake in the company and then bid to purchase it. In our view, Musk is a visionary entrepreneur and active Twitter user whose involvement could benefit the company in unexpected ways. Vuzix signed an exclusive agreement to license Atomistic’s next-generation micro-light-emitting diode display solution, with an option to acquire the company. With sufficient research and development, Atomistic’s technology could decrease the size of microdisplays in AR glasses, without sacrificing efficiency, to ensure that Vuzix’s AR glasses are ergonomic and fashionable.
The ARK Genomic Revolution ETF (ARKG) underperformed broad-based market indexes during the quarter. Among the top detractors were Exact Sciences (EXAS) and Teladoc Health (TDOC). Like smaller genomics stocks that are not in broad based benchmark, shares of Exact Sciences suffered. The company owns two of the largest cancer diagnostic franchises: Cologuard and Oncotype. In our view, Exact Sciences could own the oncology diagnostic funnel by linking screening and prognostics tests. Shares of Teladoc, the largest global digital health platform, fell significantly after the company projected that adjusted EBITDA would be 25% lower than its previous guidance, highlighting that competition for key words in the telehealth space, particularly in its DTC (direct to consumer) mental health channels, had increased its cost of customer acquisition. For perspective, the last time it traded at these levels, Teledoc was cashflow negative, with visit volumes only 17% of current levels, paid members at 50% of the current number, and annual revenue 20% of current levels. Today, 1 in 6 Americans is a full member of Teladoc, and the company is cashflow positive. Our five-year thesis for Teladoc is built around its transition from a general telehealth provider to a B2B enterprise solution for whole-person healthcare.
Among the top contributors to ARKG’s performance were Vertex Pharmaceuticals (VRTX) and 908 Devices (MASS). Douglas Melton, founder of Semma Therapeutics, left Harvard University to join Vertex and focus on diabetes treatments. In June, the company announced that US and European regulators issued key designations for its kidney disease candidate, inaxaplin (VX-147), enabling the company to expedite its regulatory work. Additionally, Vertex and CRISPR Therapeutics (CRSP) announced updated data for the gene‑editing therapy exagamglogene autotemcel, highlighting its potential to become a one-time therapy for beta-thalassemia and sickle cell disease. Shares of 908 Devices rallied sharply in June after the company showcased at the American Society of Mass Spectrometry its protocols for expediting mass spectrometry procedures. 908 Devices is a life sciences tools company that miniaturizes mass spectrometry tools to decentralize chemical and biomolecular analysis. The company also sells consumables and instruments that interface with existing state-of-the-art mass spectrometers to enhance or expand their capabilities.
The ARK Fintech Innovation ETF (ARKF) underperformed broad-based market indexes during the quarter. Among the top detractors were Coinbase Global (COIN), for reasons discussed above, and Shopify (SHOP). Shares of Shopify sold after earnings missed expectations, and management softened guidance and announced an increase in investment spending for 2022. Investors seem concerned that a recession will hit consumer spending, exacerbating the post-COVID slowdown in Shopify’s sales. In our view, the coronavirus crisis accelerated the adoption of “social commerce”.
Among the top contributors to ARKF’s performance were JD.com (JD) and Twitter (TWTR). Shares of JD.com appreciated after the Chinese government appeared to be easing its regulatory crackdown on internet companies to stimulate its economy. Additionally, the number of COVID cases receded toward the end of the quarter, bolstering sentiment in the Chinese market. Shares of Twitter contributed to performance for the reasons discussed above.
The ARK Space Exploration & Innovation ETF (ARKX) underperformed broad-based market indexes during the quarter. Among the top detractors were Velo3D (VLD), for reasons discussed above, and Kratos Defense & Security (KTOS). The Kratos Defense & Security Solutions management team issued soft guidance, citing a challenging business environment including increased raw material costs, capacity issues, and a shortage of skilled labor. Positively, however, Kratos won a contract to provide an advanced spectrum monitoring system for OneWeb’s low earth-orbiting satellite constellation. OneWeb is a communications company focused on broadband satellite internet services.
Among the top contributors to ARKX’s performance were Elbit Systems (ESLT) and Proto Labs (PRLB). Shares of drone manufacturer and defense company, Elbit Systems, rallied on news that the company had won a number of contracts ranging from $70 million over two and a half years to more than $500 million over four years. PRLB’s contribution to performance was flat, even though the company surpassed revenue and earnings expectations during the first-quarter earnings. Proto Labs is a low-volume manufacturer that leverages 3D printing for the prototyping and short-run production of custom parts.
With some of the highest conviction names from the Funds discussed above, the ARK Innovation ETF (ARKK) underperformed broad-based indexes during the quarter. Among its top detractors were Coinbase Global (COIN) and Teladoc Health (TDOC), for reasons discussed above.
Among the top contributors to ARKK’s performance were CRISPR Therapeutics (CRSP) and Cerus Corp. (CERS). Shares of CRISPR Therapeutics had a volatile quarter after the company missed first quarter consensus earnings and revenue expectations. Shares subsequently rose in response to speculation that the company could be a near-term acquisition target and to news that a well-respected new Chief Medical Officer joined to oversee the firm’s global clinical development and regulatory operations. Many research analysts also responded positively to Innovation Day, which focused on CRISPR’s strong pipeline and recent data releases. Cerus Corp., best known for INTERCEPT, its blood and plasma transfusion products, is becoming, in our opinion, the standard of care globally in the blood and plasma space.
ARK’s self-indexed ETFs, The 3D Printing ETF (PRNT), ARK Israel Innovation Technology ETF (IZRL), and ARK Transparency ETF (CTRU), depreciated and underperformed broad-based indexes and their respective benchmarks during the quarter. Shares of Velo3D were the largest detractor from PRNT’s performance, for the reasons discussed above. Shares of Arconic (ARNC), a global provider of lightweight multi-material solutions, were the largest contributor to PRNT’s performance, as the company raised full-year guidance for revenues and adjusted EBITDA. Shares of Gamida Cell (GMDA) were the largest detractor from IZRL’s performance primarily for macro reasons. On the good news front, the FDA lifted a clinical hold on one of the cell therapy company’s blood cancer treatments in April, opening the door for a phase 1/2 study. Shares of Tufin Software Technologies (TUFN) were the largest contributor to IZRL’s performance. The software company, which automates and orchestrates security policies across firewalls and hybrid clouds, announced that it has agreed to be acquired by the software-focused investment firm, Turn/River Capital. SHOP was the largest detractor from CTRU’s performance, and JD was its largest contributor, for the reasons discussed above.
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