The New Liquidity Regime Is A Threat To ARKQ (BATS:ARKQ)

Investment Thesis

In my last article on the ARK Autonomous Technology & Robotics ETF (BATS:ARKQ), I discussed how the fund was trading at a lofty valuation despite strong growth prospects and how it was hard to pick tomorrow’s winners. Since then, ARKQ is down ~13% vs a loss of ~8% for the S&P 500 and has underperformed the market. My views on this fund haven’t changed and I believe there is more pain ahead for investors who are long ARKQ.

The current liquidity regime in the US is unfavorable for growth stocks, and rates will go higher until inflation is subdued. At the same time, the risk of a recession in the US is now higher than 6 months ago. If it materializes, I believe it will have a profound impact on ARKQ given the fact that over 50% of assets are invested in cyclical stocks.

ARKQ’s Performance Since My Last Article

As a reminder, ARKQ is an actively managed ETF. The strategy invests in what ARK Invest defines as today’s leaders in the fields of autonomous transportation and robotics. You can read more about the strategy in my previous article.

I have compared below ARKQ’s price performance against the Invesco QQQ ETF (QQQ) over the last 3 months to assess which one was a better investment. Since my previous article, ARKQ has delivered a similar return compared to QQQ, although it is important to highlight that the strategy underperformed the S&P 500 by a ~5.5 percentage points margin.

Unsurprisingly in the face of poor returns, the fund experienced net outflows since February 2022. I believe this self-reinforces some of the negative performance of the fund, as in some cases, ARKQ is a top-five investor in a number of small and mid-cap companies and is therefore forced to sell when redemptions hit, putting downward pressure on the price of constituents in the process.

However, retail investors are far from capitulating and giving up on Cathie Wood and her funds. For instance, the ARK Innovation ETF (ARKK), which is her flagship strategy, experienced net inflows in January February, and March. This could potentially be a sign that the bottom isn’t here yet and there is more selling to come in the months ahead.

What’s Next?

Despite the recent drawdown, the fund continues to trade at a lofty valuation in my opinion. The P/E ratio, for instance, is still above 30x, which is much higher than if you purchase a plain vanilla NASDAQ 100 ETF. Similarly, the price to cash flow is also higher, which makes me wonder what are the real benefits of owning ARKQ at a moment in time when fundamentals are likely to become more and more important.

At the same time, inflation is now higher than at the beginning of February and probably more entrenched, which will require the Fed to continue raising rates going forward. It has been proven several times in history that inflation is negatively correlated to P/E ratios. In other words, when the CPI is high, valuation multiples are low.

The above-mentioned points are even more concerning when we look at sector allocation. ARKQ has over 55% of total assets invested in consumer cyclical and industrial stocks, two of the most cyclical categories. In other words, I don’t like the fact that ARKQ is more than 50% exposed to sectors that are very sensitive to the well-being of the economy and therefore vulnerable to an economic downturn.

Speaking of an economic downturn, the risk of recession has increased considerably in the last months in my opinion. This scenario is now more probable as economic growth has slowed down, and the recent U.S. quarterly GDP data took markets by surprise.

The PMI index is in a downtrend since Q3 2021, and it’s now far from its peak but still above 50. This index is used to measure the level of activity of purchasing managers in the private and public sectors. In my opinion, the last thing you want is to own cyclical stocks when the economic momentum slows down as you will probably be left holding the bag.

Lastly, I think inflation is now taken seriously by most market participants compared to six months ago when the consensus was that it will be transitory. This is shown in the 10-year breakeven inflation rate which reached a record high in March 2022. This is one of the best indicators of what market participants expect inflation to be in the long term. As a result, the Fed is forced to go into a tightening cycle, despite some views that suggest it will reverse course because markets are crashing. I think it goes without saying by now that higher rates will have a big impact on companies with negative cash flows and stocks that are trading at high multiples. This gives me another reason to believe that ARKQ is poised to underperform the S&P 500 in the upcoming months.

Key Takeaways

We are now in the midst of a liquidity regime shift in the US. This new regime is in my opinion negative for high-multiple stocks. Given the fact that ARKQ still trades meaningfully higher than the NASDAQ 100, it is fair to believe there is more room for multiples to go lower, which in turn will lead to declining share prices. At the same time, the probability of a US recession has increased since my last article. If it occurs, I believe it will have a significant impact on ARKQ, given that more than half of the total assets are invested in cyclical stocks.