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Cathie Wood: "Let's talk about this idea of a bubble, many commentators out there, both investors and newscasters had been referring to the really good performance in the innovation space last year as being in a bubble. And I think they feel vindicated by what is going on right now.

Well, I went through the bubble in the late nineties, I know exactly what a bubble feels like. I was there when I saw analyst and portfolio managers valuing companies by the number of potential eyeballs that would view a specific site at some point over the next 10 years.

And then again, I was there when I was new to a firm in 2001, I inherited portfolios with nearly 40% in the technology space. And believing that too much capital had chased too few opportunities too soon, meaning the technologies were not even ready. I took that 40% down to 11%, which was, according to many people I learned later, it seemed like a suicidal move because the benchmark was still at 25% in technology.

I've seen this both ways. Of course, 2001 was not the end of the tech and telecom bubble, it didn't end until 2003. And during the late 90s, I also saw that value managers were incredibly frustrated by what was going on.

They saw many of their own companies, the companies that they owned in their portfolios starting to stretch and want to become... Internet was some kind of dotcom in the description of their companies. And value managers knew very well that, that was going to end badly and it did end badly.

So the question is, are we in a bubble now? When we first started the firm Ark Invest in 2014, I remember saying a number of times, if you give us a five year investment time horizon, we believe we are a deep value manager. That is how badly innovation is priced in the public equity markets especially compared to the private equity markets.

Many people laughed at that, but we really believed it. And of course, last year the market rewarded innovation incredibly and we could no longer say we were a deep value asset manager. Because according to our estimates in research, the compound annual rate of return, we expected in mid February from our flagship portfolio and strategy was about 15% at a compound annual rate.

Well, the flagship strategies out there in our realm are down 40% to 50% from the peak. At the same time we've watched the S&P 500 and NASDAQ increase to all time highs and the PE ratio on the S&P 500 hitting 24 times. If we're looking at forward earnings and NASDAQ, it's 31 times.

That S&P number is very close to the peak, I think it was 25 times during the tech and telecom bubble. Of course, the NASDAQ went crazy and the multiple was in the hundreds, but the S&P 500 was at 25 times then and is now 24 times.

So the S&P and the NASDAQ they haven't been behaving as though there's a bubble out there, but the benchmarks are short innovation, short in a major way. They're also backwards looking. And we think that being focused on and exposed to the broad-based benchmarks over time is going to lead to very disappointing results.

It's because of the five innovation platforms that we discuss, every call, DNA sequencing, robotics, energy storage, artificial intelligence and blockchain technology. Those technologies are already for prime time. The seeds for all of them were planted actually in the tech and telecom bubble, but they've needed 15, 20, 25 years to gestate.

Now they're again, ready for prime time or already in prime time. And we know this and we have some proof points here--very important ones like Tesla, Bitcoin-- that most investors I think were thinking were a bit out there in terms of investment merits. You'll know that in 2019, many investors were sure Tesla was going to go bankrupt. We've seen Tesla, I think it hit $30 on this stock, the split stock back in 2019, and is now over $900.

It is with the skepticism we are receiving now, that the best opportunities surface. There were a lot of naysayers when it came to both Tesla and Bitcoin, and both of them have played out magnificently for us.

Bitcoin, we were talking about it, we gained our first exposure in 2015, when it was the equivalent of a $6 billion market cap or network value. We were criticized because we were fairly new to the world in terms of a sole focus on innovation, investing and some journalists thought we were trying to attract attention, and this was just a marketing gimmick. So Bitcoin, $6 billion back then has scaled to $1 trillion in six years.

We feel like we're experiencing the same nay-saying right now. And we think that our portfolios will deliver upside surprises similar to those that we have seen from both Tesla and Bitcoin.

Now, why has this happened? It started in mid February, as vaccinations were starting to spread and analyst and portfolio managers were starting to think about the future in terms of getting back to business and getting back to normal. With that shift, they also began to focus more on inflation and interest rates.

Now inflation, we had expected it because of base effects which back then certainly were part of the issue and supply chain problems. I will say that the supply chain problems and bottlenecks around the world have lasted a lot longer than we expected. So much so that today consumers have been buying in Christmas presents and holiday presents generally much sooner than might otherwise have been the case and exacerbating the supply chain bottlenecks.

Inflation does tend to benefit value strategies, energy, and financials. Especially when yield curves are steepening materials and industrials. And high rising interest rates tend to hurt innovation because they are an indication that the discount rate for evaluating the present value of future cash flows is increasing and therefore devaluing those cash flows."

Phil here... the concept that you want to review if "present value of future cash flows" doesn't make sense to you is Present Value.

In a nutshell, present value states that one dollar today is worth more than one-dollar one-year from now.

Using growth stocks as an example, this is how it works...

When buying growth companies, you're investing in (i.e. buying) future profit from that company because many of those names are unprofitable or even pre-revenue. The allure of more future dollars is the reason investors do this.

But if you can instead take that same money and invest it so that you get actual cash returns back faster than you would investing in growth companies the growth companies become less attractive. This is why interest rates are so influential for this type of investment.

Short term cash returns are easy to be had if government interest rates are higher since every quarter the government will pay interest to those holding the bonds. Therefore, if you don't expect to have a return paid to you from a growth stock for 3 years but you can get 2% on short term bonds, the bonds will attract capital away form growth stocks.

If the Fed raises interest rates, all rates for all debt instruments will go up. This will attract at least some portion of the capital allocated to growth strategies away and into debt instruments. Any selling is equivalent to decreased demand which will always put some amount of downward pressure on the price of an asset.

This is why interest rates and inflation are so important right now. If inflation persists the Fed will have to raise interest rates which will attract more money away from future-earnings companies leading to a decrease in valuation.

However, the Fed hasn't done this yet and won't do this (for awhile) if inflation doesn't persist. Should inflation numbers back off in the coming months, all the money that tried to front run the Fed raising rates could be in a precarious position.

Any way you slice it the interest rate / inflation narrative is not over and probably won't be for another year. Maybe longer if inflation does stick.

Anybody that has read my writing knows I remain on ARK's side of the transitory side of the boat. It has everything to do with supply chains. Should those iron out price pressures will be significantly less.

In addition, should inventories have been built the way Cathie Wood states, prices will end up falling naturally. All that's needed for interest rate talk to subside is CPI coming in not as hot as anticipated.

Back to Cathie...

"We've also witnessed something interesting in this market and we're trying to learn more about it, but algorithms do seem to be playing an important role in what's going on. And I'm not talking about trading algorithms and black bulls, and all of that. I'm talking about quantitatively driven algorithmic strategies.

We first learned of this in the early days of the COVID crisis, as we were watching the market react to COVID, to the coronavirus crisis. We saw some very simplistic trades quote, unquote and make obvious trades dominate the market. Back then it was okay, these algorithms seemed to be seeking out companies with small cash cushions and in cash burn situations, so small cash cushions, burning cash, and those were the two variables.

Many of the stocks in our portfolio, particularly those in the genomic space were down 50% to 75% in a matter of weeks. We leaned into that and bought them aggressively.

Of course, any thinking person looking at those stocks and understanding what they were and are, would've said, I need to look for a solution to this problem. It's probably in these genomic stocks that are going to help us sequence the virus and use synthetic biology to develop tests for virus and other research and development to develop a vaccine.

Of course our genome strategy was the best performing strategy last year, but anyone following those algorithms during that three to four week period lost out big time, if they sold the stocks that were going to help us get out of that problem. The companies were going to help us get out of that problem.

So here we are today, and I think based on this expectation of inflation continuing to go up and interest rates following, the algorithms again, simplistically are focusing on what? High valuation stocks. And I think those who are developing these algorithms--because there are human beings behind these--have a lot of muscle memory associated with the tech and telecom bubble and bust, and they're not going to repeat that mistake.

So now let's get back to inflation though, are other markets corroborating this? And it's not even other markets, as I mentioned before, while our strategies have seen significant hits to performance, we see the S&P and NASDAQ, both their prices and their PE ratios near to all time highs.

Less so NASDAQ, it got much higher during the tech and telecom bubble, but I think that's the only exception here."

Phil here... Here's the S&P 500 P/E going back to 1950.

S&P 500 price-to-earnings chart going back to 1950.

S&P 500 price-to-earnings chart going back to 1950.

And here's the relative difference in standard deviations...

Chart showing S&P 500 historical PE ration verse it's historical average since 1950.

Chart showing S&P 500 historical PE ration verse it's historical average since 1950.

There aren't any great Nasdaq historical P/E charts but I can tell you that at the height of the Dotcom bubble the QQQ's reached a P/E of 120. As of December 17, 2021 it stands at 29.4.

Here's what we can say for sure. With inflation and the printing of gobs of money, no one is quite sure where the P/E of these indexes should be. But I think it's accurate to say that these ratios should naturally be elevated and stay that way permanently. We did, in fact, dump about 30% more US dollars into the economy.

FRED M2 Money Chart Going back to 1950.

FRED M2 Money Chart Going back to 1950.

It's clear to me that the broad market is overvalued by some degree. But what about ARKK?

Here's the historical price-to-sales for the ARKK ETF going back to it's inception in 2014. It shows the median price-to-sales in the ETF for each day the ETF has been around.

Historical price-to-sales chart for ARKK from bucketfox.com

Historical price-to-sales chart for ARKK from bucketfox.com

You wouldn't call where we are today a bubble. Is it elevated? Yes. But let's go back to the idea of adding 30% more dollars to the money supply. If we were to adjust everything accordingly then ARKK's current P/S would be about 11% above it's historical high.

Just how realistic is this? At least somewhat. That much money will always inflate asset prices. But just how much is unclear. Either way, huge bubble? No.

Back to Cathie...

"We're also seeing in the private world, no recognition of what's going on. And so we get in, in the last week, NU (NuBank) going public. NuBank is a fintech stock. It was valued in January at a funding round at $25 billion. It just went public at a $40 billion valuation, that's a 60% increase. At the same time that MELI (MercadoLibre), which is also in the fintech space, and is growing nearly as rapidly as a NuBank. It's stock has been cut in half, so the private markets have no notion that this is a problem for valuations."

And then the bond market itself is beginning to question this. It's been interesting to watch since the end of March, the bond yield, the long-term treasury bond yield here in the United States falling. It's gone from 1.75% to about 1.45%, so 30 basis points as inflation has been escalating.

FRED chart showing Market Yield on U.S. Treasuries for 10-year bonds going back to 2017.

FRED chart showing Market Yield on U.S. Treasuries for 10-year bonds going back to 2017.

Now, and if you look at the yield curve what's happening is it's flattened, it's gone from 160 basis points in at the end of, I think in February, to roughly 80 basis points, it's been cut in half.

FRED Chart for 10-2year yield curve going back to 2001.

FRED Chart for 10-2year yield curve going back to 2001.

Now, normally, if inflation is an issue, long-term interest rates go up more than short-term interest rates. Even the day that Chairman Powell said that he was beginning to question whether inflation was transitory, the bond market rallied.

Now, those who are very focused on the bond market will know that there are inflation break evens there, the tip bonds, where we have an understanding of what the market thinks inflation is going to look like over the next five years, five to 10 years. That particular number rose to I think, nearly 2.8% or roughly 2.8% at its peak, and now has dropped nearly 40 basis points in the last few weeks.

FRED chart showing the 10-Year Breakeven Rate going back to 2017.

FRED chart showing the 10-Year Breakeven Rate going back to 2017.

So inflation expectations in the bond market are coming down. In fact, I'll throw it out there just because as I think this means something to people on the bond market, it broke below its 200 day moving average for the first time since July of 2020.

So the bond market is beginning to wonder if inflation, not just beginning to wonder, it's beginning to suggest that inflation is going to be transitory. And we would submit and as we have for some time now, that the bigger risk out there is not inflation, it is deflation."


📣 For a full summary, notes, and transcription of ARK's December 13th Webinar--plus all the other webinars since early 2021--join Cathie's Ark Trading Floor. Webinar summary, notes, and transcription can be found here.