2023-04-12 02:06:29 ET
Summary
- Cathie Wood's ARKG provides investors with an opportunity to take advantage of the billion-dollar genomics market.
- However, it has performed poorly compared to XLV's higher-quality holdings in a period where the Fed has aggressively hiked interest rates.
- Also, with inflation-led high wages and costs, there should be relatively less healthcare spending this year, which does not augur well for the ARK fund.
- Still, there could be a trading opportunity in case of the bank earnings season revealing that economic conditions are deteriorating further and the Fed pivots.
- To provide investors with a glimpse of this opportunity, I start by highlighting the price action during the banking turmoil which grappled the market in the second week of March.
Despite short positions in the ARK Genomic Revolution ETF ( ARKG ) managed by Cathie Wood hitting a record high of 13% in the second week of March, it still managed to deliver gains of 4.33% from March 10 to 24 as per the deep blue chart below.
In so doing it outperformed the Health Care Select Sector SPDR ETF ( XLV ) with higher quality holdings by 1.8%, which appears abnormal in the current context where interest rates remain high, normally detrimental for Cathie Woods's picks which have to spend a lot of cash to sustain their higher growth metrics.
Moreover, these performances which contrast sharply with those of the longer term , where it is XLV that has been much less volatile need to be studied in the context of the Federal Reserve's actions on interest rates, with the ultimate aim being to assess whether ARKG can produce an upside.
First, I provide insights into its holdings.
Billions of Dollars of Opportunities in Genomics
As per the very name of the actively managed Exchange Traded Fund, its holdings have been chosen given their relevance to advancing and disrupting the genomics theme coming from the health care, materials, energy, IT, as well as consumer discretionary sectors.
In this respect, some will remember that sequencers or devices which identify genes, played a key role in the development of treatments and vaccines, namely by understanding and mapping the DNA patterns of the SARS-CoV-2 virus. This development can be termed genetic epidemiology and before that, vaccine development took decades and enabled people to continue on with their daily lives after whole populations were inoculated.
ARKG Top 10 Holdings (ark-funds.com)
Furthermore, when you think of the high prices which governments had to pay for Covid vaccines in 2021 and 2022 and the market valuations of developers like Moderna (NASDAQ: MRNA ) which reached nearly $190 billion at its peak, it becomes easier to understand why this is a multibillion-dollar global market or $54.4 billion by 2025 to be more precise.
Therefore genome research is no more at the lab stage as in 2003 when the Human Genome Project successfully sequenced and mapped the Homo sapiens genome.
The subsequent genomics revolution not only gave rise to the innovative research field of genome sequencing but also paved the way for precision medicine and personalized treatments. which means that ARKG’s holdings can actually perceive revenues for services they offer to patients.
ARKG's Troubles Amid Higher Rates
However, in an economic environment that is radically different from 2020/ 2021 as a result of monetary conditions becoming much tighter, one metric which has started to matter more is cash, in addition to just revenue. In this case, as pictured below, with the exception of Exact Sciences ( EXAS ) and Teladoc ( TDOC ) which both generate money from their operations, the other holdings consumed cash as per the last reported quarter.
In contrast, the higher quality healthcare names with good balance sheets, cash generation capacity, and profitability held by XLV like Johnson & Johnson ( JNJ ), Eli Lilly ( LLY ), AbbVie ( ABBV ), etc. have performed better from 2022, resulting in the ETF outperforming ARKG as shown in the orange chart below. As for the ARK fund, it surged and knew its moment of glory in early 2021 with the onset of the "cheap money" in March 2020 with borrowing costs falling to near zero as the Fed drastically eased monetary policy in order to boost spending following the economic freeze triggered by Covid.
Coming back to the shorter-term price action (as per the introductory chart), ARKG's upside coincided with the Silicon Valley Bank's failure and the ensuing banking turmoil which saw some U.S regional banks in deep stress after suffering from bank runs. As a result, in order to obtain liquidity, banks had to sell assets, but since a sizeable portion was constituted of long-duration treasuries meant that the overall value went down because of higher interest rates.
Learning from the Banking Turmoil
Now, one of the reasons for long-dated treasuries being devalued to such an extent is that interest rates were hiked rapidly thereby increasing yields. Conversely, due to the inverse yield-value relationship, the market value of these bonds fell lower than the price they were initially bought, resulting in losses for banks that had to dispose of them. This problem gave rise to fears that certain banks might not dispose of sufficient liquidity to repay customers, including contagion fears that led depositors to withdraw money en masse from smaller banks to either put these in larger ones or money market funds.
However, ARKG, together with other genomic-focused funds were also among the beneficiaries as well as the Invesco QQQ Trust ( QQQ ) as shown by their one-month price performances below.
Comparison with peers (www.seekingalpha.com)
Subsequently, considering financial stability risks, the Federal Reserve moderated the pace of hiking interest rates, with a 25 basis points rise in March compared to 50 by the European Central Bank. Additionally, with tools like FDIC (Federal Deposit Insurance Corporation) guaranteeing depositors' money and the Federal Home Loan Bank Funding for ensuring the availability of liquidity, the market was calmed.
Subsequently, the JOBS report for March where non-farm payrolls ticked at 236K or 2K less than expected, but with the unemployment rate declining to 3.5% (against expectations of 3.6%) implies that the Fed's actions are working, at least in reducing the number of job openings, and that the U.S. central bank need not be as aggressive to address the inflation problem. However, this will ultimately depend on CPI or Consumer Price Index data to be released on Wednesday.
Interestingly, the Fed’s Cleveland branch forecasts that headline inflation will increase by only 5.2% in March compared to 6% in February. This will certainly weigh on the Fed’s decision with some market participants now anticipating a 67% chance of a 25 basis point hike on May 2-3. Going one step further, according to a survey by Bankrate, more than 50% of experts expect this to be the last interest rate rise in 2023.
Now, typically when the Fed pauses, this is good for tech stocks, but the most important source of support for Cathie Wood’s fund may come from the woes of the banking sector as majors report earnings as of April 14. Now, just like for job numbers, the slowing economy is likely to reduce risk-taking appetite thereby impacting loan growth. Worst, with deteriorating conditions, banks may have to adopt a more defensive posture and be more stringent when scrutinizing the credit profiles of borrowers, and may even be forced to add provisions against potential losses.
A Possible Trading Opportunity
With banks lending less money, this means less liquidity in the system and it is the more cyclical stocks like consumer discretionary or those which are exposed to the cyclicality (ups and downs) of the economy which typically suffer, not specialized care whose fortunes depend more on secular trends. To explain this, behind the market action which catches our attention daily, there are some underlying structural forces like the aging population, tackling of rare diseases, and technology-enabled disruption.
In this respect, a breakdown of ARKG's holding on a per-technology basis shows that it has exposure to diagnostics, gene therapy, and other treatments.
ARKG Breakdown (ark-funds.com)
Still, as per a report by Economist Intelligence , a dose of realism is required as healthcare spending in 2023 will be adversely impacted by higher wages and other costs. On the other hand, the report is favorable to the digitalization of healthcare, a sector in which ARKG has a 5% exposure.
Pursuing on a positive note, the quarterly progression in cash and equivalents during the last year shows that the ETF's holdings have done an effort to cut down on costs, but is important to assess whether this will not impact revenue growth in 2023.
Therefore, patience is required as to how ARKG's holding will evolve in the era of tight liquidity, especially considering that secular trends can be slow-moving and take years to unfold.
However, a 25 basis point Fed interest rate hike plus dovish comments by its Chairman Jerome Powell may be sufficient to propel the ETF to the $35-36 resistance level. This would represent nearly a 20% upside from the current $19.6 share price and be much more than the 4.3% rise experienced during the banking turmoil, which was caused by speculation that the Fed would have to adopt a more dovish stance in order to prioritize financial stability over price stability.
In conclusion, with a potential Fed pivot, tech, and ARKG should deliver considerable upsides, but, investors are reminded that after the initial euphoria, there is not likely to be a sustained upside as the odds of a recession occurring this year have gone up.
For further details see:
ARKG: A Probable Window Of Opportunity, Depending On Banks And The Fed