ARK Innovation ETF ARKK: the bottom is not reached, going from sale to conservation

Thesis

On December 15, we wrote an article on ARKK in which we explained why we strongly believed that a violent sell-off was in the cards for the fund. Although not as vertical as expected at the end of the year, the sell-off nevertheless materialized two weeks later with a violent fracture of the High P/E Tech space currently underway. ARK Innovation ETF (ARKK), a flagship of easy-money innovation trading, is the standard-bearer of the “new normal” brought on by the specter of higher rates. The normalization of rates results in a sharp sell-off on the once high-flying darlings of the stock market. “The bigger they are, the more they fall” goes an old adage, and for ARKK it’s no different. Despite Cathie Wood’s near-ridiculous attempts to save a sinking ship, the bubble has burst and it will take time to repair itself from a fundamental and technical standpoint. Innovation trading is certainly not dead, but it is resetting to more normalized P/E and valuation metrics. Once the dust settles, it will be useful to revise the ARKK fund, but at much more acceptable entry levels. While we don’t believe the bottom has been reached for the ARKK fund, we believe the easy money from the short sale has been earned and is moving from To sell at Hold after the violent vertical sell-off we expected materialized.

Performance factors

The factors we identified in our original article are the culprits for this downward vertical movement:

The Fed

The market has moved from our original article to pricing near four rate hikes This year:

From the chart above, we can see how the OIS market is now implying an overnight rate of around 1% by the end of the year. Overnight index swap is an interest rate swap where periodic fixed payments are tied to a given fixed rate while periodic variable payments are tied to an overnight rate compounded daily. Market practitioners can view current OIS swap pricing for information on market views on fed funds at different times.

Some market players are even starting to talk about a Super Hawkish Fed some trying to hedge against a 50 basis point rate hike at the next Fed meeting. We don’t think the Fed is going to go “nuclear” and raise rates by 50 basis points given the jolts this can cause in markets from a liquidity and repricing standpoint, but the simple fact that some market participants are considering such actions speaks volumes about the new interest rate environment we are entering.

Investor flows

Capital outflows from ARKK have accelerated and the attractiveness of the entire Tech sector is in question. ARKK has benefited in the past from being the standard bearer of a thriving innovative technology sector that would change the world overnight and deserve dizzying valuations based on belief rather than numbers. 2022 and higher rates have resulted in a sharp rotation from technology to value, which is symptomatic of capital reallocation due to lower pro forma cash to be provided by the Fed. Massive investor flow have driven stock prices higher in 2021 and the Tech to Value rotation that is underway just means that the ARKK components and the fund itself are going to be pushed lower in price by lowering valuations. ARKK companies have raised prices due to pure belief and outsized investor allocations, and as the environment normalizes, they will deflate to a level where annual CAGRs are in line with fundamental performance and achievement of said promises. The performance is also boosting investor flows and ARKK has only been losing investor money over the past year. Any rational investor who does not benefit from a very low historical entry point (i.e. a cost base in the $50 or lower range) is going to be further pressured by this underperformance and wonder seriously if its capital would not be better allocated elsewhere in 2022 .

Achieved performances

The vertical sale of ARKK that we expected happened in the first weeks of 2022:

And if we look at the publication date of our original article, we can justify our return performance:

We talked at length in our original article about the factors that would cause such a vertical move down and that the technical setup was very poor for ARKK, with a massive vertical move down expected from our side. This move happened, albeit with a slight delay, and we’re happy to take some money off the table after a big annualized gain.

The current price action does not suggest a bottom has yet been reached for ARKK, but we expect a dead cat bounce to occur sooner rather than later given the overloaded technical indicators:

We can see from the chart above courtesy of Seeking Alpha that stretched levels of the RSI (i.e. approaching 30) tend to be followed by short “dead cat” bounces that normalize a stretched technical condition.

From a fundamental perspective, we need to see the Fed raise rates, we need to see P/E levels normalize on underlying companies, and we need to see some awareness of the “innovations” that companies launch into daily life so that we begin to believe the story again. The era of “belief” money ended with inflation and the Fed, and higher rates just mean investors have more options when it comes to allocating capital and so stocks that have been inflated only by stories in the past need to start delivering on their promise.

Conclusion

ARK Innovation ETF emerged from anonymity on the back of zero rates and investors’ over-belief in the history of transformational technology. Strength fed on strength and as more capital began to flow into the vehicle and strategy, the fund burst into the public consciousness as a great way to make easy money out of thin air. . With a performance of +156% in 2020, ARKK captured the imagination of investors for a new, unknown corner of the capital markets that would enrich investors who dared to believe. Traditional valuation metrics became a thing of the past and Cathie Wood continued to delight viewers with the mirage of overnight cross-industry transformation via the companies ARKK was buying from. The Fed and higher rates have put all that on hold and reality sets in. Much like a beautiful love story that is driven by feeling and dreams at the start, ARKK’s story hits the stark reality of results investing and delivers on promise. Higher rates mean there are more opportunities in town and transformation stories are increasingly going to be compared to results and cash flow. The end of ARKK is not here and the Tech is not dead, but we are seeing a return to earth for an investment vehicle that had no borders not so long ago. just like Icarus which flew too close to the sun only to crash to earth, ARKK has seen its best days in the sun and is once again becoming a “normal” investment vehicle with good and bad years. We believe that the easy money from the short sale was made on ARKK and we are moving from To sell at Hold after the violent vertical sell-off we expected materialized.