ARKK: The Real Rate Rebound Is Bad News For Cash-Flow Negative Stocks

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Technology stocks have had a strong year, outperforming the S&P 500 by over 15% with a 40% return.The ARK Innovation ETF ARKK has performed poorly compared to the overall technology sector, rising by ...

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class=\"meta\">\n\n\n2024-04-18 02:24 GMT+8&nbsp;&nbsp;&nbsp;<a href=https://seekingalpha.com/article/4684290-arkk-real-rate-rebound-bad-news-for-cash-flow-negative-stocks><strong>seekingalpha</strong></a>\n\n\n</h4>\n\n</header>\n<article>\n<div>\n<p>Technology stocks have had a strong year, outperforming the S&P 500 by over 15% with a 40% return.The ARK Innovation ETF ARKK has performed poorly compared to the overall technology sector, rising by ...</p>\n\n<a href=\"https://seekingalpha.com/article/4684290-arkk-real-rate-rebound-bad-news-for-cash-flow-negative-stocks\">Source Link</a>\n\n</div>\n\n\n</article>\n</div>\n</body>\n</html>\n","isBrief":false,"type":0,"news_type":1,"symbol":"IE00B3M56506.USD","symbol_name":"NEUBERGER BERMAN EMERGING MARKETS EQUITY \"A\" (USD) 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it.ARKK's top holdings have high valuations, face competition, and most lose money, making them risky investments.The top holdings in ARKK are significant enough that they cannot quickly expand much further yet continue to hemorrhage cash.As individual investor cash allocations slip, I believe ARKK is a short opportunity and will decline quickly as the remaining speculative fuel dries up.   blackdovfx The technology sector has had a great twelve months, rising by ~40%, outperforming the S&P 500 by over 15%. For the most part, technology stocks have found reprieve as the inflation outlook has cooled, causing many to adjust valuations for tech stocks in hopes that interest rates will decline. Further, I argue that the sector has benefited from a resurgence in speculative buying activity stemming from a decline in individual investor cash allocations. The rally was driven by investor exuberance surrounding AI, with Nvidia (NVDA) leading the market higher. It may seem that the many smaller, high-growth technology firms in the once-popular ARK Innovation ETF (NYSEARCA:ARKK) should have performed well. Many of those firms are AI-oriented, of course. However, its performance since I covered it last year has been paltry. ARKK has risen by 12% since my bearish take. Admittedly, a 12% return is not low if we consider the standard of most stocks, but for the highly volatile ARKK, a 12% gain could be erased in a matter of days. If we consider ARKK's minor gains compared to the stellar gains of the less volatile technology sector, then it seems that the ETF is still stagnant. Much has changed in the technology sector, the macroeconomic backdrop and ARKK's investing focus over the past year. Thus, I believe it is an excellent time to cover it again to determine if its slight rise may indicate a more significant breakout or a potential short point. Changes to ARKK's Investment Focus Since I last covered ARKK, some changes have been made to its holdings. Today, the ETF remains heavily invested in Tesla (TSLA) (9.8%), Coinbase (COIN) (9.7%), Roku (ROKU) (7.6%), Block (Square) (SQ) (6.9%), and UiPath (PATH) (5.7%). The top ten holdings in ARKK range from many sectors, giving the ETF unique economic exposure to a wide range of growing industries. I agree that each company in ARKK's top holdings is an innovator in developing markets. To me, there is little denying Cathie Wood's ability to pick innovative companies in key markets. However, the common thread in the top ten holdings is that they all have terrible valuations. Most lose money despite being huge and established firms. If not, they're like Tesla (TSLA) and have a magnitude larger valuation than their competitors. See below: Data by YCharts It is one thing for a company to be innovative and another to be a good investment. Yes, innovation is critical to growing into a new market. However, buying a great company at an insensibly high price will not deliver positive returns in the long run. Further, if that company is burning cash without regard, it could eventually fail if investors decide to stop giving it their money. Investors in growth stocks must keep in mind that, for the most part, corporate managers are incentivized to dilute equity if valuations are high, offsetting negative profits while encouraging top-line growth. CEOs benefit from high sales growth, and investors benefit from high earnings per share growth. Moreover, investors in these ten companies may fail to realize their competitive risks. Besides Roblox, I'd argue the other nine have pretty close competition. They may have first-mover advantages, but all face competition to a degree, particularly from private companies. Investors seem to focus on competition from other public companies because they can easily compare them, and private firms get less media attention. However, private market competition is tremendous in the AI and biotech markets. Why Interest Rates Matter for ARKK I'd argue ARKK is, in fact, one of the most interest-rate sensitive ETFs on the market. Usually, stocks and bonds have a negative correlation. However, every month, the correlation between ARKK and the long-term Treasury bond ETF (TLT) is a staggering 84% today. See below: Data by YCharts ARKK is highly correlated to long-term bond prices. That may confuse some, as ARKK invests in high-growth equities while TLT is in no-growth Treasury bonds, which usually rise in value when economic growth slows. However, the correlation stems from the fact that because ARKK companies are cash-burners, they rely on a low time value of money. Long-term Treasury rates determine the long-term time value of money. Most of the ARKK companies chronically depend on external capital from either debt or equity markets to offset their negative net incomes. Further, investors value ARKK companies based on the prospects of high potential cash flows at some point, years into the future. Since we're valuing those firms based on expected income five years from now, according to Wood, we must discount the losses and cash over that period according to interest rates. As rates rise, the discounting factor grows, lowering the present value of those firms. Some may feel that since the Fed is expected to cut rates later this year, that is a non-issue. For one, the inflation rebound, which I've covered for months, may stop the Fed from cutting rates. Further, rate cuts have no direct impact on longer-term Treasury rates, which are determined by open markets, albeit heavily influenced by QE and QT in recent years. Unless the Fed decides to use \"Yield Curve Control,\" rate cuts will not lower the long-term time value of money, primarily determined by the monetary system. Historically, ARKK negatively correlates to the real interest rate on long-term Treasuries. That stems from the fact that, as an equity, ARKK is not exposed to an inflationary rise in interest rates but more of an increase in rates compared to inflation. When real rates were meager in 2020, ARKK skyrocketed as borrowers were essentially paid to take money. The opposite is true today; notably, real Treasury rates are rising again. See below: Data by YCharts There is debate regarding the most recent rise in long-term Treasury real rates. Fundamentally, it is a sign that rates will be above inflation or that there is a high degree of risk that inflation increases. In my view, that is understandable given the massive acceleration in the Federal deficit (particularly on interest expense). As such, FDI into the US is slipping while global central banks avoid or sell US Treasuries. Stocks, like those in ARKK, also have deficits and require external cash. As that slows, US stocks' valuation premium should also fall. The Bottom Line Fundamentally, ARKK's strategy was built during the \"free money era,\" it remains geared to that paradigm, which passed in 2022. The \"free money era\" existed after 2008 as the US government shifted toward more enormous deficit spending. The Federal Reserve held rates low with low inflation while waves of QE pumped freshly minted cash into the monetary system. Companies could easily tap public cash bases to offset negative cash flows, allowing them to make long-term innovative investments that could not pay off for years. Today, the opposite is true. Some companies, such as Nvidia and many others, accelerated out of the easy money era by stabilizing and growing their profit margins. Others, such as most in ARKK, continue to pretend that they can burn cash without regard, but are now at risk of diluting their remaining market capitalizations. Investors can earn a 5% return risk-free, so they have little reason to invest in a stock that is burning cash and may finally raise its EPS to a 5% earnings yield five to ten years into the future. Further, most of the companies in ARKK are already very large. They may not grow further due to competitive pressure (Tesla, Robinhood) or the need to obtain sufficient market size (Zoom, Roblox, Unity, etc.). From a top-line standpoint, I'd argue that most stocks in ARKK do not have nearly as much sales growth potential as their valuations imply. Still, they continue to position themselves as if they were increasing while relying on external financing. Individual investors with extra cash tend to like the stocks in ARKK. Thus, I'd only bet against ARKK if investors lack the extra cash to buy these speculative and overvalued firms. See below: Data by YCharts The AAII survey on investor cash shows a marked decline since 2023, fueling the rally we've seen over the past year. That said, individual investor cash levels are now back around their median level, meaning there is less side-line fuel for the rally. Hence, the stock market's performance is slowing significantly. There is still some side-line cash today, but it is likely earning a decent yield, disincentivizing further speculative investment. Still, ARKK may rebound, as speculative fervor shifts from the largest technology firms to the smaller ones.  Overall, I am bearish on ARKK today and believe it is a solid short opportunity at its current price, albeit with a fair degree of risk that speculative momentum lifts these stocks higher. Technology and bitcoin have done well lately, as in 2020-2021. Back then, ARKK tracked the others, so that may occur again. However, since ARKK has not performed well despite those two, I believe it points to a negative relative trend in ARKK. ARKK's short borrowing cost is 2%, and it could rally so that I would limit position sizing. That said, I expect ARKK to decline over the coming months, with the potential to reverse its recent gains quite quickly as general market momentum seems to be slowing.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2428327640"}