Can ARK Invest Stay Afloat in the Inflation Flood?
Founder Cathie Wood thinks deflation will come to the rescue.
ARK Invest manages exchange traded funds (ETFs) focused on investing in disruptive innovation. Its founder, Cathie Wood, is interested in exponential growth opportunities, and her funds do not shy away from companies that are currently unprofitable or trading at PE multiples in the several hundreds.
Although this strategy has been deemed too risky by traditional fund managers, ARK Invest believes that many of their investments will become dominant future technologies that generate outsized returns.
However, many of ARK’s funds have experienced large declines over the last year. For example, ARKK, their flagship Innovation ETF (in which Tesla is the #1 holding), is down nearly -50% from its all-time-high reached in February of 2021. Their Genomic Revolution ETF, ARKG, which was enthusiastically touted in 2020, is down -54% since its high around the same time.
Of course, this has led many to double-down on criticisms of ARK’s seemingly reckless strategy. Owing to the concomitant period of record-high inflation that has correlated with these declines, some critics have argued that much of ARK’s suffering is the result of inflationary pressures, which have steered investors into a ‘risk-off’ mindset.
Value is Risky, Innovation is Value
Cathie Wood has consistently pushed back on these characterizations, saying she believes that ARK’s ETFs are now in deep value territory after these major declines. In fact, Wood argues that traditional benchmarks, in particular those stocks which are considered value stocks, are where the major risk lies.
“We do not believe that most asset allocators have enough allocated to innovation…Because of these innovation platforms — DNA sequencing, robotics, energy storage, artificial intelligence, blockchain technologies — because those are going to rip through the traditional world order, and disturb it mightily, those benchmarks are probably where we’re seeing the bubble today,” said Wood.
Clearly, Cathie Wood believes that the markets are underestimating the potential of new technology. In her mind, she does not need to be more like traditional fund managers, rather she thinks they should be more like her.
“What I find so interesting about movements in the market today is, the fear of interest rates and inflation picking up really started in February of this year when people were starting to get vaccinated, and the markets went after our strategy to express the risk and basically shorted our strategy.”
Here, Wood seems to be implying that the attack on her funds was a displaced reaction to the broader macroeconomic environment, in particular inflation and the Federal Reserve’s impending response. She has also pointed out on numerous occasions that many investors have a short term investment time horizon, while her funds take on a 5 year or longer time horizon for their targets. She believes that, when looking out 5 years, her funds have gained much more upside potential.
“In mid-February this year, as we did our 5 year forecast — and we assume massive multiple compression during the next 5 years to something like FAANG multiples: EV to EBITDA in the 18 to 20 range — the compound annual rate of return we expected from our portfolios was roughly 15%. Today doing that analysis, some of our projections have increased. The compound annual rate of return we are expecting is close to 40%. So in February we are expecting a doubling over 5 years, today we are expecting nearly a quintupling over 5 years.”
Deflation Not Inflation
ARK’s investment strategy is not the only contrarian position Cathie Wood is expressing. As many economists, investors, and politicians are beginning to sound the alarm on inflation, Wood believes that we will be seeing deflation rather than inflation in the near future.
In a Twitter thread posted on October 25th, 2021, Wood wrote,
“Now we believe that three sources of deflation will overcome the supply chain-induced inflation that is wreaking havoc on the global economy. Two sources are secular, or long term, and one is cyclical. Technologically enabled innovation is deflationary and the most potent source.”
The first secular source of deflation Wood cites is technologically driven cost declines. The particular examples she regularly discusses are declines in the cost of DNA sequencing and AI training (which she says are declining 40–70% annually). She believes that one consequence of these cost declines will be a reduction in the velocity of money as individuals and businesses push off purchases of goods and services in anticipation of future price reductions. She calls this type of deflation good deflation.
The second, secular source of deflation, according to Wood, is a bad type: the disintermediation of companies that haven’t innovated. Instead of innovating, some companies have chosen to buy back shares and pay dividends to appease shareholders. Wood believes these companies will be forced to service their debts by selling increasingly obsolete products at lower prices (i.e. deflation).
The third, cyclical, source of deflation, which Wood says is the most controversial, is the cancellation of double and triple orders by businesses as supply chain bottlenecks ease. As examples, she refers to corrections in the price of lumber, copper, and iron ore. She thinks companies over-ordered because of supply bottlenecks, and we will see many of these orders canceled. The cancellation of these orders should lead to a decrease in the cost of commodities.
Although it appears Cathie Wood thinks deflation, not inflation, is the prevailing risk in the future, there are currently few signs of deflationary pressures at the moment. This minority viewpoint also conveniently portends a positive future for Wood’s investment strategy, raising the question whether biases associated with the strategy are causing ARK to ignore arguments for permanent and increasing inflation (voiced by individuals like Peter Schiff, Michael Saylor, Jack Dorsey, and Ray Dalio).
But this is really an issue of lack of clarity in cause and effect, or the proverbial chicken or the egg dilemma. For if Wood genuinely believed deflation was the true risk, she would likely be pursuing the same strategy she is pursuing today. On several issues, ARK appears to have a dissenting viewpoint. In many ways, this a good thing. Mark Twain once said, “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”
However, Twain did not say that one should always be on the side of the minority. To hold a dissenting viewpoint, for the sake of remaining in the minority, can be equally dangerous. In doing so, one risks losing objectivity, which is the key idea Twain was originally alluding to.
It may be that Cathie Wood sees something happening, macroeconomically, that the others don’t. But it is also possible that she is part of a minority that misses something obvious, sitting in plain sight.
“On inflation we do have a controversial call here. I think the prevailing wisdom is we have an inflation problem — this is not transitory. And I will say that the supply chain bottlenecks have lasted a lot longer than I would have expected, and the latest version of that is consumers running out and buying holiday gifts well before they normally would because of supply chain issues that might prevent them from buying presents later,”
The Velocity of Money and Inflation
Deflation or, at least, a reduction in the rate of inflation has not set in as quickly as Wood expected back in October of 2021. It is interesting to look back at what originally sparked her lengthy Twitter thread outlining the 3 sources of deflation she anticipated.
On October 22, 2021, Jack Dorsey tweeted, “Hyperinflation is going to change everything. It’s happening.” Dorsey’s tweet was met with considerable backlash. Many people called him irresponsible and alarmist for insinuating that America could experience hyperinflation. It is important to point out that some parts of the world are experiencing, or are on the verge of experiencing, hyperinflation. These countries include Turkey, Venezuela, Argentina, and Lebanon, for example. Dorsey did not specify which parts of the world were experiencing hyperinflation in his tweet.
Three days later, on October 25, Cathie Wood replied to Dorsey, tweeting, “In 2008–09, when the Fed started quantitative easing, I thought that inflation would take off. I was wrong. Instead, velocity — the rate at which money turns over per year — declined, taking away its inflationary sting. Velocity still is falling.”
Here, Cathie Wood states that, when the velocity of money decreases, inflation decreases. She claims that this is why we didn’t see inflation following the Great Recession and implies that this is why we won’t see it in the future. Does this make sense?
To understand what Wood is saying, it is important to understand how the velocity of money is calculated. The usual equation that is provided is:
V =PQ/M=(nominal GDP)/M
where M is the money supply, V is the velocity of money (the rate at which people spend money), P is the general price level, and Q is the quantity of goods and services produced. The product PQ, is equal to nominal GDP, i.e. prices times outputs. V can be thought of as the number of times one dollar is spent to buy goods and services over a period of time. The larger the number, the more people are transacting with each other in the economy.
In a 2014 article published on the Federal Reserve Bank of St. Louis website, economist Yi Wen echoes Wood’s logic, writing:
“Based on this equation, holding the money velocity constant, if the money supply (M) increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference. According to this view, inflation in the U.S. should have been about 31 percent per year between 2008 and 2013, when the money supply grew at an average pace of 33 percent per year and output grew at an average pace just below 2 percent. Why, then, has inflation remained persistently low (below 2 percent) during this period?… The issue has to do with the velocity of money, which has never been constant... If for some reason the money velocity declines rapidly during an expansionary monetary policy period, it can offset the increase in money supply and even lead to deflation instead of inflation.”
The velocity of money did decrease rapidly in 2008–09. However, in 2020 the velocity of money decreased more sharply than in 2008 and the decline was even larger on a percentage basis than in 2008. It continues to fall. At the same time, we are at record high inflation levels. The official CPI inflation number for December 2021 is up 7.0% over 12 months.
If we look back at the formula for velocity of money, this is also a plausible scenario. Hypothetically, if the money supply, M, increases by +25%, the prices, P, increase by +7%, and the real economic output, Q, increases by +10%, we would still observe a -6% decline in the velocity of money. In other words, we can still have very high inflation in prices (7%), while simultaneously observing a decline in the velocity of money. The key point is that a massive increase in the money supply can outstrip nominal GDP increases.
But even beyond this, what if the inflation numbers are not accurate. What if inflation is 15% instead of 7%? In such a case, we should see a +1% increase in the velocity of money, but in reality we aren’t because the true price level is not accurately reported.
Therefore, the relationship between inflation and the velocity of money is not as clear as Cathie Wood makes it seem. Seeing as this is the original premise for her bet on deflation, it probably requires more in depth examination. If we continue to experience increasing inflation over the coming years, this will create problems for businesses of all types, not simply technology growth stocks. Those that cannot grow faster than the minimum inflation hurdle rate will face the threat of extinction. Whether individual investors fall in the majority of alarmists or minority of optimists, the future consequences will be felt by all.