Q4 2021: Commentary From ARK’s CIO

ARK Invest,

December 31, 2021

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.

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