Last week, as you may recall, we marveled at the investment bravado of Cathie Wood, the uber-successful and uber-confident founder of ARK Investment Management.

In case you missed it, we noted that Ms. Wood dismisses sky-high stock valuations as irrelevant, while also brushing aside today’s high inflation readings as a fleeting, inconsequential blip.

In Wood’s view, today’s unprecedented tech innovation justifies higher company valuations. Additionally, she argues, technological advances are cutting costs, so inflation won’t be a problem either.

Even though the CPI inflation rate jumped to a 30-year high shortly after Wood issued her upbeat outlook, she recently doubled down on that forecast. “Once the holiday season passes and companies face excess supplies, prices should unwind,” she confidently tweeted.

“Three sources of deflation will overcome the supply chain-induced inflation,” she insisted on Oct. 25. “Technologically enabled innovation is deflationary and the most potent source.”

Therefore, rather than worry about worrisome facts like record-high stock valuations, Wood continues pouring billions of dollars into stocks with no valuation whatsoever.

That’s right; the combined earnings of the top 25 holdings in the ARK Innovation ETF (NYSEARCA:ARKK) are ZERO!

That’s not a typo. If you were to combine the annual earnings from each of the 25 companies that occupy the top 25 spots in the ARKK portfolio, you would discover that their combined GAAP net income from the past 12 months was less than zero.

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That’s because only seven of those 25 companies posted an annual profit, while the remaining 18 posted a loss. Somewhat incredibly, the combined market value of these 25 stocks is currently $2.2 trillion, of which Tesla (NASDAQ:TSLA), the single largest holding in ARKK, accounts for half of that total.

That’s a novel approach to portfolio construction, but investors can’t seem to get enough of the profit-lite concoction Wood has been serving up. $9 billion has flowed into the ARK Innovation ETF during the past 12 months.

History Isn’t on Wood’s Side

“Wood-mania” is certainly understandable, based upon the recent track record of this intrepid money manager. During the past five years, the ARK Innovation ETF has delivered a total return of nearly 600%, more than three times the return of the S&P 500 index.

ARKK’s performance in 2021 has not been quite as stellar. It is showing a 2% loss versus the S&P 500’s 26% gain. Perhaps this is the pause that refreshes.

On the other hand, perhaps ARKK’s pricey portfolio is beginning to feel the gravitational weight of investor expectations. Even the most exciting of “story stocks” must turn a profit eventually if it is to retain its buzz.

Wood may be correct to dismiss the twin threats of high inflation and high valuations, but history is not on her side.

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As the chart below shows, periods of high inflation readings, coincident with high equity valuations, produce dismal investment results, relative to periods of low inflation and low valuations.

For example, during periods when stocks were trading for more than two times sales and the CPI was over 3%, the S&P 500 Index produced a 10% loss over the following five years, on average.

That’s what the far-left bar on the chart shows. By contrast, the far-right bar shows that when stocks were selling for less than one-time sales, and inflation was below 3%, the S&P soared 177% over the following five years, on average.

Clearly high stock valuations, coupled with high inflation readings, provide a suboptimal foundation for stock market gains.

Today, stocks are trading for an all-time high valuation of 3.14 times sales, while inflation is hovering around 5.4%. Neither number is a source of comfort.

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Moments like these can be challenging… but not hopeless.

Stock selection is paramount. Stock selection and a portfolio construction that includes positions that can benefit from rising inflation, rather than fall victim to it, is key.

Traditionally, gold and commodity plays have led that quirky, inflation-loving category of investments. But these types of stocks are not the only ones.

I’ve been recommending select inflation-resistant stocks to my subscribers… and will continue to do so until the inflation threat subsides.

Regards,

Eric Fry

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