Summary
- Initial jobless claims is an important metric to follow because the Fed will taper and raise interest rates when substantial progress is made towards maximum employment and 2% normalized inflation.
- May's jobless claim (385,000) came in lower than consensus estimates (393,000), which suggests that substantial progress has been made and a great valuation reset will likely follow.
- One way to mitigate devaluation during the great reset is to rotate into cash- or value-oriented stocks because companies with visible earnings sustain less devaluation from higher required return.
- This article found that ARKX is most resilient to devaluation compared to other ARK ETFs because its holdings have the highest margin of safety (lowest PS ratio and PE ratio).
- However, investors should note that ARKX has higher liquidity risk when interest rates rise due to higher exposure to aviation and negative net interest income.
Background
Unemployment is a very closely monitored metric because of its significant implication on the stock market. According to Jerome Powell's guidance, the Fed will only consider tapering QE and increasing interest rates after substantial progress towards maximum employment and a normalized 2% inflation rate.
Analysts are speculating that the Fed will taper and increase interest rates as soon as this year-end. The initial jobless claims in May may have just validated their prediction. The jobless claim numbers released on Thursday are considered to be substantial progress for 2 reasons. Firstly, it fell below 400,000 for the first time since the Covid-19 pandemic. Secondly, the number (385,000) came lower than the consensus estimate (393,000).
If the analysts' predictions are realized, the great valuation that we all fear will very likely follow. In such circumstances, value-oriented stocks with strong and visible earnings will be more resilient than growth stocks.
Cathie Wood ARK ETFs are known to focus on innovation and growth. She said that:
I do believe if rates were to take a sharp turn up, that we would see a valuation reset and our portfolios would be prime candidates for that valuation reset of course.
However, at that time, the ARK Space Exploration & Innovation ETF(BATS:ARKX)has not been established yet. Therefore, ARKX may not be one of the prime candidates for a valuation reset. Furthermore, Cathie Wood said that investors could find many value-oriented stocks in ARKX. This should mean that ARKX should be more resilient than the other ARK ETFs.
Therefore, this article examines how resilient ARKX is compared to the other ARK ETFs during a valuation reset.
Chart 1: Initial Jobless Claims
What is ARKX in the eyes of its creator?
According to Cathie Wood, ARKX is currently mainly connectivity and precision agriculture with autonomous tractors and drones. These applications are powered by a common technology, a constellation of satellites. Other than connectivity and precision agriculture, hypersonic flights are also what ARKX is very interested in, and the involved companies tend to be value stocks.
Therefore, ARKX's holdings are built around companies involved in those supply chains. ARKX's holdings as of 3rd June 2021 are presented in Table 1.
Table 1: ARKX's holdings as of 3rd June 2021
How do we examine a fund's resilience?
We're going to examine ARKX's resilience using the following metrics:
- Distribution of profitable companies in each fund's top 10 holdings
- Distribution of P/S ratio of each fund's top 10 holdings
- Distribution of P/E ratio of each fund's top 10 holdings
- Net interest income of each fund's top 10 holdings
- Operating cash flow of each fund's top 10 holdings
These metrics are chosen using the following rationale:
- Profitable companies are less prone to valuation reset. Therefore, funds that hold more profitable companies are less prone to valuation reset as well. P/E and P/S ratios are chosen as a measurement of valuation.
- Net interest income shows how much interest expense is incurred by the company. In contrast, companies with positive operating cash flow are less likely to borrow money when the cost of capital is expensive. Free cash flow isn't used because free cash flow can be derived from the sale of assets or financing.
How resilient is ARKX in a valuation reset compared to other ARK ETFs?
Distribution of profitable companies in each fund's top 10 holdings
Chart 2 to Chart 5 illustrates the PE ratio of ARK ETFs' top 10 holdings. PE ratios of loss-making companies are not applicable. The distribution of profitable companies in each fund's top 10 holdings is presented in Table 2. We can observe that only 66% of ARKX's top 10 holdings are profitable. This is incomplete as the degree of profitability relative to its valuation is not considered.
Table 2: Distribution of Profitable Companies
| Funds | Distribution of Profitable Companies |
| ARKX | 66% |
| ARKK/ARKW]] | 60% |
| ARKQ | 80% |
| ARKF | 70% |
Source: Author, YCharts
Distribution of P/S ratio of each fund's top 10 holdings
PE ratio reflects a company's degree of profitability relative to its valuation. Our perspective changed when we consider the PE ratio of the funds' top 10 holdings. We observed that the PE ratio of ARKX's top 10 holdings is significantly lower than other ARK ETFs' top 10 holdings. This implies that ARKX's holdings have the highest margin of safety, such that ARKX is the least prone to sharp decline compared to other ARK ETFs.
Chart 2: PE ratio of ARKX's top 10 holdings
Chart 3: PE ratio of ARKK/ARKW's top 10 holdings
Chart 4: PE ratio of ARKQ's top 10 holdings
Chart 5: PE ratio of ARKF's top 10 holdings
Distribution of P/S ratio of each fund's top 10 holdings
Since the loss-making companies from ARK ETFs' top 10 holdings are not considered when analyzing PE ratio, we examine their PS ratio for a more robust comparison. Chart 6 to Chart 9 represents the PS ratio of ARK ETF's top 10 holdings.
The conclusion from the PS ratio comparison aligns with the PE ratio comparison. ARKX's top 10 holdings have the lowest PS ratio than the top 10 holdings of other ARK ETFs. This also implies that ARKX has the highest margin of safety compared to other ARK ETFs.
Chart 6: PS ratio of ARKX's top 10 holdings
Chart 7: PS ratio of ARKK/ARKW's top 10 holdings
Chart 8: PS ratio of ARKQ's top 10 holdings
Chart 9: PS ratio of ARKF's top 10 holdings
Net interest income of each fund's top 10 holdings
Chart 10 to Chart 13 represents the net interest income of ARK ETF's top 10 holdings. The higher the net interest income, the better. This is because higher interest rates will boost both interest income and interest expense.
ARKX's top 10 holdings have the worse net interest income, where only 1 of the 10 companies enjoys positive net interest income. We found that this is due to higher exposure to aviation-related companies. For instance, Boeing (BA) has taken a $13.8bil loan to help deal with cash burns due to the pandemic.
Nevertheless, ARKX's holdings are likely to suffer more interest expense (and decreased earnings) as the Fed starts selling corporate bonds and raise interest rates. If interest rates become too burdensome, these holdings might even face higher liquidity risks than other ARK ETFs' holdings. Therefore, ARKX is not as resilient to rising interest rates compared to other ARK ETFs.
Chart 10: Net Interest Income of ARKX's top 10 holdings
Chart 11: Net Interest Income of ARKK/ARKW's top 10 holdings
Chart 12: Net Interest Income of ARKQ's top 10 holdings
Chart 13: Net Interest Income of ARKF's top 10 holdings
Operating cash flow of each fund's top 10 holdings
In terms of cash flow from operating activities, the top 10 holdings of ARK ETFs have similar performance, except Boeing. This means that ARK ETFs' top 10 holdings can generate cash flow from its core business. Hence it is less likely that the companies will require debt for operation when interest rates rise. No standout winner in this category.
Chart 14: Operating cash flow of ARKX's top 10 holdings
Chart 15: Operating cash flow of ARKK/ARKW's top 10 holdings
Chart 16: Operating cash flow of ARKQ's top 10 holdings
Chart 17: Operating cash flow of ARKF's top 10 holdings
Conclusion and final remark
May's initial jobless claims can be considered as the substantial progress the Fed is referring to. A great valuation will likely follow in the event of the Fed's taper tantrum and rising interest rates. Therefore, it is important to rotate into cash- or value-oriented stock as companies with visible earnings will sustain less devaluation from higher required returns.
Cathie Wood claimed that ARKX has a lot of value-oriented companies. This is true, as evident from the PS ratio and PE ratio of ARK ETFs' top 10 holdings. Therefore, ARKX is indeed more resilient to devaluation from rising interest rates.
However, investors should note that ARKX's holdings are more prone to liquidity risks as its holdings are more exposed to aviation-related companies such as Boeing.