ARKK - Stagflation Playbook: Short Tech (QQQ/ARKK) And Long Healthcare (XLV)

2023-08-22 03:19:40 ET

Summary

• We believe 2H 23 to be a critical inflection point that investors should rebalance their portfolio to a more defensive sector as we expect sticky inflation and rising interest rates.
• The healthcare sector's fundamental is stronger than ever and the regulatory overhang around IRA is overblown.
• We believe that AI/tech bubble may deflate when investors realize that interest rates may continue to go up and above 3% inflation is here to stay for the foreseeable future.
• We recommend a long healthcare and short tech pairs trade strategy for investors during 2H 23 and 24.

Pairs trade thesis: long healthcare and short tech

This report provides an updated perspective on our previously articulated pairs trade strategy that we shared in 1H 23 : long on the healthcare sector, represented by ETF ( XLV ), and short on the technology sector via ETFs such as [[QQQ]] or Cathie Wood's Ark Innovation ETF ( ARKK ).

We concede that during 1H 2023, our pairs trade faced challenges, primarily due to the surge in tech behemoths like Google, Microsoft, Facebook/Meta ( META ), and NVIDIA ( NVDA ). This surge was largely attributed to unforeseen AI hype after the launch of ChatGPT in 2H 22. Additionally, investor sentiment around potential Federal Reserve rate cuts further buoyed these stocks, which offered a relatively safe exposure to the tech realm. Notably, ARKK did not participate in this surge, indicating that a faction of investors remains cautious (in our view), potentially awaiting consistent indicators like sustained inflation at the targeted ~2%.

We reaffirm our recommendation to long healthcare and short technology, delineating our strategy for the latter half of 2023 and early 2024. Our conviction stems from three main arguments. Firstly, despite recent underperformance mainly coming from regulatory overhang around IRA , healthcare fundamentals are robust, and the concerns are overblown, in our view. Regulatory challenges, particularly fears of government-imposed drug price caps by the IRA, have dampened the sector. However, significant legal challenges are underway against such caps from major big pharmaceutical giants claiming the IRA is unconstitutional. We believe there is a good chance that the big pharma sector to win the case and IRA will be dialed down, softening the impact.

Merck & Co (MRK) sued the U.S. government on Tuesday, seeking to halt the Medicare drug price negotiation program contained in the Inflation Reduction Act (IRA), which it argues violates the Fifth and First Amendments to the U.S. Constitution.

This is the first attempt by a drugmaker to challenge the law, which the pharmaceutical industry says will result in a loss of profits that will force them to pull back on developing groundbreaking new treatments.

Source: Reuters

We expect the healthcare sector to re-rate to the upside moving into 2H 2023.

Secondly, tech valuations have soared, reminiscent of the 2021 highs-when interest rates were near 1%. This growth is primarily driven by expectations of the Federal Reserve halting rate hikes. Notably, the Buffett Indicator has surged 22% from its September 2022 levels, standing at 170.2% as per GuruFocus data. With the inflation now coming back up with the rising oil prices, there is a good chance that the big tech stocks that benefited from the AI hype to start re-rating downwards, moving back to the 2022 2H low (or perhaps below). Lastly, macroeconomic landscapes haven't shifted substantially since September 2022. With inflation rising , as evident from July 2023 data and rising oil prices that seem to be accelerating, and the Fed indicating persistent rate hikes, the tech sector faces a daunting environment, as evidenced by the recent weakness that we have seen during the last two weeks.

In an anticipated stagflationary scenario, sectors that retain pricing power and aren't discretionary will thrive. Healthcare, especially the biopharmaceutical sub-sector, embodies this resilience. Essential healthcare services, such as crucial drug treatments, will retain demand (as patients and payers (i.e., insurance) still pay for drugs/services during the recession), unlike discretionary services like streaming platforms (i.e., Netflix) that may be the first thing that consumers cut down when they lose their job. Furthermore, we believe that companies like Google and Meta, that are glorified marketing companies in a way, will face challenges going into recession as fewer companies will use their platform for marketing as consumers cut down their spending as people's disposable income gets destroyed by inflation, higher mortgage rates and slow growth in paychecks (as evident by recent statists that showed that credit card debt hit a new peak ). Even if the Inflation Reduction Act (IRA) sets price limits at inflation levels, it essentially allows drug companies to match inflation in their pricing-a luxury other sectors don't possess.

ETFs to consider

As our thesis is based on macroeconomic shifts and considering the fact that most investors lack the knowledge of picking individual stocks in the healthcare sector (considering its complexity), we recommend investors consider broad well-diversified blue-chip focused ETFs such as XLV.

For the short side, we believe shorting either QQQ, a broad NASDAQ 100 ETF, or Cathie Wood's ARK Innovation ETF (for investors who are willing to take more risk) would be appropriate. Unlike the other ETFs mentioned above, ARKK is an actively managed ETF run by Cathie Wood that mainly focuses on SMID-cap technology stocks. Cathie Wood has a remarkable ability to choose the most hyped up cashflow negative (majority of her stocks) stocks that we believe will perform terribly during the current macroeconomic environment. That being said, as it is actively managed, there is a chance that she choose to rebalance her portfolio to more defensive stocks, and investors should constantly monitor it for anyone considering shorting ARKK.

Although we are bullish on the biotech sector ( XBI ) ( IBB ) in general due to the recent M&A momentum that we have seen in 2023, we recommend more of a broad healthcare ETF that includes MedTech and healthcare services that are less volatile than pre-commercial biotech. Please read our recent article on the biotech sector's M&A activity and why we are bullish in the biotech sector for more detail. Of note, there are short NASDAQ ETFs like SQQQ and SARK available for investors who do not want to borrow shares from the brokerage account. However, there could be some degree of tracking error and higher management fees associated with it.

Risks to our thesis

Shorting tech, while seeming lucrative, carries inherent risks. Technology remains a cornerstone of innovation, and any disruptive breakthrough can alter valuations overnight. Likewise, while healthcare appears resilient, policy changes or global health crises can introduce volatility. It's essential to diversify and maintain a balanced portfolio to mitigate these sector-specific risks. Furthermore, the potential risk remains if FED decides to cut down interest rates in the near future as the Tech sector will benefit from it the most, and shorts could lead to bigger losses than the potential upside coming from healthcare depending on the net exposure. As such, we only recommend investors who are high-risk takers to consider our pairs trade.

Conclusion

Revisiting our pairs trade strategy, we continue to champion a long position in healthcare, underpinned by its robust fundamentals and innate pricing power. Conversely, the tech sector, despite its recent rally, appears vulnerable in the current macroeconomic scenario. For investors seeking exposure to these views, broad ETFs like XLV for healthcare and QQQ or ARKK for technology offer suitable avenues. However, investors should remain vigilant, considering the inherent risks in sector-specific bets and rapidly changing sentiment around interest rates and inflation rates.

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