On Thursday, Catherine Wood (Trades, Portfolio)’s Ark Invest saw its flagship Ark Innovation ETF (ARKK, Financial) soar 14%, recording its best single-day gain since inception in 2014. This remarkable comeback was driven by the news that inflation is finally beginning to ease in the U.S., rising only 0.4% in October compared to the previous month for a 7.7% increase year over year. This was lower than analysts had been expecting.
As a growth stock investor, Wood’s holdings have been decimated this year after the Covid market bubble burst and discount rates increased due to high inflation and interest rates. Even after Thursday’s encouraging results, the Ark Innovation ETF is still down approximately 61% year to date. However, if inflation continues to ease, could we see a more sustained recovery for Ark’s funds?
The case for easing inflation
Consumers have been hit hard by cost of living increases this past year as daily necessities such as housing, food and energy soared in price. Meanwhile, companies have been hit by the triple-whammy of inflation, reduced consumer spending power and higher interest rates on any debt they need to take on or refinance.
However, inflation indicators tend to lag behind reality, meaning that by the time we see the numbers in the headlines, people have already long been feeling the effects in their bank accounts. The CPI, for example, takes into account all leases for its housing component, regardless of whether they were renewed last month or a year ago.
Some analysts are already calling the end of high inflation as the Federal Reserve’s interest rate hikes have made significant progress in halting rent increases and energy supply chains stabilize in the U.S. following initial disruption from sanctioning Russian energy exports due to the Russia-Ukraine war. In September, the Case-Shiller Home Price Index posted its first monthly decline since the financial crisis, indicating housing costs could ease further.
Rather than seeing inflation in the future, Wood takes a contrarian stance and expects deflation to develop due to disruptive innovation making certain goods obsolete while artificial intelligence will supposedly reduce production costs. Wood also notes that several leading inflation indicators are pointing toward the end of high inflation. Gold peaked two years ago, while other commodities that were affected by temporary price spikes have dropped double-digits from their all-time highs.
With the Federal Reserve’s aggressive rate hikes added to the mix, overshooting on inflation control does seem possible, especially because the more debt the public has, the less real control the Fed has over inflation.
Additionally, a paper released at the latest Jackson Hole summit, written by Francesco Bianchi of John Hopkins University and Leonardo Melosi from the Federal Reserve Bank of Chicago, theorized that as long as government spending remains high, the Fed could actually make inflation worse by raising interest rates.
However, there is no denying that rent and energy prices are stabilizing, which should also help to curb food price hikes, though we may still see more pain on this front due to crippling droughts in many parts of the world.
Waiting for a Fed pivot
Regardless of the reasons behind it, if we do see inflation continue to ease in the months ahead, it would likely boost growth stocks as investors factor in a reduction in discount rates.
However, given that Ark’s Thursday boost was driven by broad market enthusiasm following the inflation report, it seems likely that it will not be sustainable in the weeks and months to come, not until we see more consistent numbers indicating further inflation reduction is in the cards.
There is also one key factor that will likely hold investors back from supporting a sustained market rally: the Fed is still hawkish. While the central bank may have lost some of its ability to directly influence markets over the past four decades, it still has control over borrowing rates and any individual or company that has to take on additional debt or refinance in a higher-rate environment will feel the bite.
This means the stocks of companies that have strong balance sheets, good cash flows and low amounts of leverage are still in favor for now. Only once the Fed pivots its policy stance and begins to ease interest rates again will we have the potential to see the tide rise for growth stocks again.
What’s in store for Ark?
By midday on Thursday, more than 28 million shares of the Ark Innovation ETF had changed hands, surpassing the fund’s 30-day average volume of about 25 million and indicating renewed interest in growth stocks. The top performers in the ETF included Unity Software Inc. (U, Financial), which was up 29%, and Invitae Corp. (NVTA, Financial) with a gain of 38%. In comparison, the S&P 500 was up just 5.54% for the day.
History has shown time and again that growth stocks are a bubble and burst experience. Their dramatic ups and downs are driven by the disproportionate speculative component of their valuations. That is why even for growth stocks, long-term investing success relies on buying lower than your estimates of future real earning potential and holding long-term winners for many years.
All in all, I think Thursday’s rally is unlikely to keep up the pace for Ark until we see inflation ease further and begin translating to relief for growing companies that are strapped for cash. I see some merit to Wood’s thesis that disruptive innovation could have long-term deflationary effects on certain parts of global resource and data supply chains, but I would prefer to see more real results on how this plays out before making any bets on it.
