Rising U.S. interest rates and inflation at multidecade highs is waking investors up to the fact that a vivid imagination is no way to buy a stock. Until recently, the investors who had the richest imaginations seemed to make the most money — until they lost their gains in a matter of months.
ARK Innovation ETF
is a prime example — the poster child of the recent hysteria and until 2021 one of the U.S. market’s best-performers. Shares more than quadrupled from the pandemic lows to the ETF’s peak in February 2021. Never mind that some of the companies in its portfolio had business plans that looked right out of a sci-fi novel — they were going to revolutionize the world (and their out-of-this-world valuations supported that claim).
Cathy Wood, ARK Innovation’s fund manager, became an instant celebrity. The media and Wall Street did what they usually do — hailed her as the next Warren Buffett. The performance of ARK Innovation, the flagship of Wood’s firm, was compared with the then relatively abysmal performance of Buffett’s Berkshire Hathaway
held up as proof that vibrant, future-thinking Wood had left has-been nonagenarian Buffett in the dust.
The better ARK Innovation performed, the more the money flowed in, and the more sci-fi stocks it bought. Often ARKK became the largest shareholder in smaller companies, pushing their stock prices higher, which in turn drove the ETF’s net asset value higher. This created more “FOMO” for investors, attraced more assets, and divorced the stocks ARKK held from reality. ARK Innovation’s assets surged in less than a year from $2 billion to almost $28 billion at its February 2021 peak.
It’s easy to pick on Cathy Wood. We should not. If not her, it would have been a manager of another fund. The stock market, like many other asset classes, was overtaken by a temporary insanity, triggered by a combination of low interest rates and enormous liquidity flushed into the system by Uncle Sam. For some time, the market was rich in imagination and scarce in common sense.
This movie is now ending in a predictable way. Higher interest rates are bringing stocks back to earth. Investors who bought into ARK Innovation at the peak are down about 75%. Anyone who bought ARKK after mid-April 2020 and held has lost money in the fund.
Things fall apart
There is an interesting parallel between the run-up and crash in digital-tech stocks since the COVID-19 pandemic and the Y2K bubble of 1999. The stock market was already frothy in the late 1990s, full of dot-com speculation. In 1999 corporations were concerned that at the turn of the 21st century computer clocks, instead of taking us forward from 1999 to 2000, would take us back to 1900. Though this was a real risk only for old mainframe computers, it triggered a tsunami of upgrades to new software systems.
This combination of Y2K fever and demand for dot-coms that were going to ride the internet wave and revolutionize the world led to rising sales for computer makers and other technology companies, substantially boosting their earnings.
Then the clock turned to a new century, with no problem. Tech companies discovered that pre-Y2K sales had pulled forward future demand, and dot-com companies ran out of other people’s money to fund their profitless growth (sound familiar yet?). Investors expected soaring sales to continue but got a decline in sales instead.
Tech stocks collapsed. Not just Pets.com, but real companies including Dell Computer, Cisco Systems
Some, such as Cisco, experienced a sales decline for a few years and then resumed growing. Dell and others had a pause in sales growth for a year, while the lucky ones, like Microsoft, saw sales marching higher as if nothing had happened.
Investors who held shares of these companies had to wait more than a decade for prices to regain their 1999 highs. That is how long it took for earnings to grow into 1999 valuations. (Cisco to this day has not reclaimed its 1999 high).
“ The price you pay for a stock matters, and great companies get overvalued. ”
I have made this point many times: The price you pay for a stock matters, and great companies also get overvalued.
Just like tech companies during the Y2K/dot-com bubble, digital-tech companies received a significant boost to their sales during the COVID lockdown. But sales only tell a small, superficial part of the story. These companies have undergone a significant readjustment of their cost structure.
When a company grows quickly, management cannot help but draw straight- or even parabolic lines into the future, preparing the company for growth to continue, hiring staff and investing in assets, all to support the future nirvana. Yet as the growth rate slows, comes to a stop, or actually goes negative, companies are forced to renormalize their employee and asset bases. This brings layoffs, and the contraction can be contagious, as these companies frequently consume each other’s products, causing some to see even greater sales slowdowns.
Ronald Reagan said, “A recession is when your neighbor loses a job; a depression is when you lose yours.” By this definition Silicon Valley now is going through the early stages of either a recession or a depression, depending on where each company sits.
Recessions are healthy, because they shift management’s focus from outward (growth) to inward (operations). Prolonged high growth is not healthy. It creates a lot of inefficiencies, inflating corporate cost structures. When imagination runs wild, a stream of sci-fi projects get funded.
One can hope for the bubble to reinflate under these stocks. History suggests otherwise. Bubbles rarely hit the same group of stocks twice. There is a psychological reason for this: holders who were burned on the first ride usually unload these stocks into run-ups. Also, this would require inflation to dissipate and interest rates to revisit new lows.
Here’s what I think will happen with tech stocks: the downturn likely will get a lot worse in 2022 and maybe the next few years. Digital companies that were loved yesterday and are still liked will see their valuation and stock price fall further. Investors’ affection for them may change to hate, then to indifference, as they embrace new shiny objects.
It is hard to see this now, but some of these companies will be left for dead. This is what happened to many tech/dot-com darlings in the early 2000s. Some will become attractive opportunities; others will fade into irrelevance. As a money manager, it then becomes my job to dig through the rubble to find faded market darlings with the potential to recover, and buy their shares at a bargain price.
Vitaliy Katsenelson is CEO and chief investment officer of Investment Management Associates. He is the author of “Active Value Investing: Making Money in Range-Bound Markets,” and “The Little Book of Sideways Markets.”
Here are links to more of Katsenelson’s views of the inflation landscape (read, listen) and how to invest in inflationary times (read, listen). For more of Katsenelson’s insights about investing, head to ContrarianEdge.com or listen to his podcast at Investor.FM.