Like a Mob Boss, I Just Can't Escape This Life

Like a mob boss, I just can't escape this life... They're pulling me back in... The latest chapter in the Cathie Wood saga... The 'genius of timing' is at it again... Speculative bubble stocks are starting to fall apart... It hasn't hit the broader market yet – but it will... Wood's success is spawning imitators...

'Just when I thought I was out, they pull me back in'...

Most Digest readers likely know where that memorable movie quote comes from. But if you don't, it's from actor Al Pacino playing Mafia don Michael Corleone in The Godfather Part III.

I (Dan Ferris) won't spoil the entire movie plot... in case you still haven't seen it 31 years after its release. But essentially, Corleone is trying to become a legitimate businessman. And yet, he's simply not able to escape the mob life... Things just keep pulling him back in.

That's pretty much how I feel today about the markets – and my ongoing bearish outlook...

I really don't enjoy being the bearer of bad news for Digest readers and all of my Extreme Value subscribers. But when we're living in a world full of so much speculative excess, it's impossible to escape... The signs of an impending market top are all around us today.

With that in mind...

It's time for the latest chapter in the saga of ARK Investment Management and CEO Cathie Wood...

After all, we haven't discussed this "classic sign of a bubble topping out" since October 15.

Just to recap a little...

In the February 11 Digest, I called Wood "the Gerald Tsai of today" – referring to the current speculative mania in the market. And I compared her company to Tsai's Manhattan Fund...

Tsai was the golden boy of fund manager Fidelity in the 1950s and early 1960s. And then, fresh off years of spectacular performance managing the firm's Capital Fund, he left in 1965 to start his now-infamous Manhattan Fund. But the good times didn't last... The Manhattan Fund peaked in 1967 and lost 90% of its value by 1969.

In February, I likened ARK Investment Management's exchange-traded funds (ETFs) to Tsai's Manhattan Fund... I called them the "Mother of All Signs of an Impending Top."

Today, my concerns about Wood and Ark Investment Management appear more justified than ever...

For example, the company's flagship ARK Innovation Fund (ARKK) is heading the wrong way for investors...

ARKK's share price peaked the day after my original Digest. It closed at an all-time high of $156.58 per share on February 12. Shares closed today at $93.53 – a loss of roughly 40% in less than 10 months. The stock is now trading at its lowest level since late October 2020.

Meanwhile, the benchmark S&P 500 Index is up more than 15% since February 12... And the tech-heavy Nasdaq Composite Index is up around 7% over the same period.

In other words, ARKK already might be going the way of the Manhattan Fund.

If you've read my Digests on Wood, you know I've also praised her obvious talent...

Among other attributes, her timing has been brilliant...

After all, Wood went "all in" on disruptive-innovation stocks with high conviction starting at the founding of her company in 2014. Anybody who bought ARKK shares when they began trading in October 2014 is still up more than 350% today. At the peak in February of this year, the ETF had soared roughly 680% since its inception.

I still believe the "fad" nature – and until the past 10 months, the dramatic outperformance – of her company's ETFs is a massive sign that the epic bull market of the past decade is getting long in the tooth. Still, credit is due... I must acknowledge her achievements.

Wood's latest move is also brilliant – and another reason why I feel like Corleone right now...

You see, Wood is testing a potential new fund... It will hold short positions on stocks that she believes are being disrupted by the innovative companies in her firm's ETFs.

In a recent interview with CNBC, Wood referred to the fund as "ARK on steroids."

Wood told the financial-news network that ARK is only testing the fund internally with employees right now... And she didn't say when (or if) it would become available as an ETF for retail investors.

Now, you might be wondering why I believe this is "brilliant" – and I really mean that...

After all, as you know, selling stocks short is risky... And ARK's overall innovation-focused strategy is risky as well. So why would I tell you such a strategy "on steroids" is brilliant?

The short answer is that Wood's timing is brilliant yet again. The long answer is...

ARK's success is the direct result of a massive, speculative bull market feeding frenzy. And for ARK, at least, it sure looks like that feeding frenzy has peaked...

It's a major problem for Wood and her company that the ARK Innovation Fund is down around 40% from its February 12 peak. No matter what Wood says in public, I promise that she has been sweating bullets as she watches the value of her flagship fund – which holds around 60% of ARK's assets under management – fall so much.

So with that in mind, what should Wood do now?

Exactly what she's doing.

She should be starting a fund that's ostensibly true to her core thesis of exploiting disruptive innovation... but is really just a way to make money as the bull market falls apart.

Let's face it...

During the next bear market, investors will sell everything. They won't stop with the flaky, often-unprofitable innovators in ARK's ETFs...

Terrified investors will sell their shares of companies in the S&P 500, the Nasdaq, the Dow Jones Industrial Average, and more. They'll offload everything they can in order to raise enough cash and get enough risk off the table to make themselves feel better.

That's how it works when a stock market bubble bursts...

The risky, speculative names – like the ones ARKK holds – start falling apart.

To cut their losses, investors sell their positions. That causes the share prices of these companies to fall more. The supply of shares offered for sale grows as prices fall. It overwhelms demand and causes prices to fall off a cliff.

When speculative profits turn to big, quick losses, the speculators get nervous... They start selling whatever stocks they own to try to preserve whatever profits they have.

If it gets bad enough, they'll suck up the penalties and taxes to raid their 401(k) accounts. As a bubble bursts, selling on the way down can become as indiscriminate as buying was on the way up.

It takes time for the losses in speculative bubble stocks to hurt the broader market, but they eventually do...

Take the housing bubble, for example...

The S&P Homebuilders Select Industry Total Return Index peaked in the summer of 2005, according to data compiled by Bloomberg. The S&P 500 Financials Index, which was full of banks that lent money to buy all those overpriced homes, peaked in February 2007. And Home Depot (HD), the largest home-improvement chain, peaked in July 2007.

So the bubbliest stocks in that era peaked over a span of roughly two years... And yet, it took until October 2007 for the S&P 500 to hit its housing-bubble peak.

The index of homebuilders had already fallen 57% by then!

Eventually, the S&P 500 fell 58% from its housing-bubble peak. That's because investors sold whatever they could to make up for the massive losses in homebuilders, banks, and subprime mortgage stocks.

The dot-com bubble is another example...

The Nasdaq peaked on March 10, 2000. Then, the index dropped 37% in about two months through May 23. Meanwhile, the S&P 500 only fell 1.5% over that same time frame.

On January 2, 2001, the story was similar... The Nasdaq had plunged 54% at that point, but the S&P 500 had fallen just 8%.

Eventually, though, the selling hit the broader market... The S&P 500 ultimately bottomed out after falling 44% from its dot-com-era high.

If the innovation bubble continues to burst, the damage will hit the broader stock indexes at some point...

The dot-com bubble mostly focused on technology stocks. So roughly half of all Americans who owned brokerage accounts back then suffered as the good times ended.

The housing bubble wreaked havoc on the stock market, the housing market, and the banking industry... In one way or another, it involved the finances of virtually every household in America.

Related to that, it's worth noting... the broader housing bubble took the S&P 500 down farther (58%) than the tech-focused bubble (44%).

That's scary because today, it's an "everything bubble."

Stocks, bonds, art, wine, housing, high-end real estate... it's hard to find an asset class that isn't overvalued. And with so many things involved, it'll be hard to avoid the devastation.

This time, the bear market (whenever it arrives) could take the S&P 500 down 60% or more.

Now, we're definitely nowhere near that point yet...

Even though ARKK is down roughly 40% from its February peak, the S&P 500 is only about 3.5% below its November 18 all-time-high closing price of 4,704.54.

In other words, the damage hasn't come anywhere near the broader market yet. If the bear is already here... it's still just a cute and cuddly cub. Nobody is worried about it today.

With that said, Wood seems to be one step ahead again. She must know that if a bear market develops in the big indexes as it already has in her ETFs, it won't discriminate...

It will take down the disruptors, the disrupted, and everything in between.

That's why she can credibly start a short fund focused on the "disrupted value traps" that she told CNBC are in the big indexes. Her fund will likely underperform funds that sell short the popular, speculative stocks that fill up her ETFs... But it will perform better and better as the damage bleeds into the S&P 500.

Of course, one short ETF won't save her firm in a brutal bear market...

The ARK Innovation Fund's assets have seen large outflows since its share price peaked back in February, when we first wrote about it as a sign of the top. If the innovation bubble doesn't start reflating, it'll take more than a single short fund to reverse that trend.

I'm not saying Wood isn't a true believer in her disruptive-innovation strategy...

Wood truly believes buying disruptive innovators and selling short the disrupted companies will earn good returns. She's confident that innovation is an unstoppable force regardless of what the stock market does over any period of time.

She's probably right, and that's a big part of the problem...

You see, getting the long-term macro thesis right doesn't always mean you'll get great investment returns. It doesn't even mean you won't lose money! ARK's ETF holdings could get absolutely crushed even if Wood's thesis is correct and all the disruptive companies thrive while the disrupted businesses struggle.

As Wood told CNBC...

In five years, the world will look nothing like it does today, and we're invested in all the disruptors, the winners, that are going to disrupt the traditional world order.

Again, Wood is probably right... But she failed to mention that those disruptors could keep disrupting the "traditional world order" for years to come and still see their share prices plummet 80% or more from peak levels.

That's exactly what happened to the 'Nifty Fifty' stocks of the late 1960s and early 1970s...

If Wood had been operating back then, she would've owned all the Nifty Fifty stocks.

They were the "no brainer," buy-and-hold forever stocks that everybody assumed would go up forever... That's because everybody "knew" their businesses would never stop growing.

Three of the most prominent Nifty Fifty names were Avon, Xerox, and Polaroid. They sold the products and technologies that everybody at that time was certain would dominate the future. As Forbes magazine summed it up, investors believed that...

[T]hese companies were so good that it didn't matter what you paid for them; their inexorable growth would bail you out.

The Nifty Fifty bubble crashed like bubbles always do...

Those no-brainers that you could buy and hold forever were bludgeoned by the bear market that peaked in January 1973 and bottomed in October 1974. Xerox fell 71%, Avon fell 86%, and Polaroid fell 91%.

Though their share prices were destroyed, all three businesses did well for several more years. Of course, the inevitable winds of change eventually swept over all three companies.

Today, absolutely nobody can fathom a future without the hottest names in the market...

I'm talking about Amazon (AMZN), Apple (AAPL), Netflix (NFLX), Alphabet (GOOGL), Tesla (TSLA), and Facebook – which was recently renamed Meta Platforms (FB).

At the same time, no one can fathom these companies' growth slowing or stopping altogether... Nor can they fathom their share prices falling 70% or more.

Take Tesla, for example. It's the No. 1 speculation of the current era...

In the November 5 Digest, I showed you how "the tail is wagging the dog" with the options market propelling the massive move higher in Tesla's share price. The options market is putting rocket fuel under the stock, causing Tesla's valuation to rise far beyond anything reasonable.

Tesla bulls account for an enormous chunk of the market for short-term call options these days... Those folks are all trying to make a lot of money very quickly.

But what happens when Tesla disappoints the market in some way and the call-option buyers retreat? Will the drop in Tesla's share price be as sudden and dramatic as its ascent?

The latter outcome will surprise everyone... But it should surprise no one.

The great herd of investors picking up easy money in Tesla's call options suffer from a lack of imagination...

If you can't imagine the possibility that Tesla will fall 80% or 90% over the next few years, you don't have enough imagination to be a great investor.

You must learn to do what legendary investor Warren Buffett calls "seeing around corners." You need to be able to imagine that what everybody else believes is wrong is really right, and vice versa.

But please don't misunderstand me... I'm not telling you to be a knee-jerk contrarian. I'm simply telling you to cultivate the skill of anticipating a wider range of possible outcomes.

Likewise, I try to temper my bearishness with respect for Wood's achievement in building Ark Investment Management.

However, Wood better learn quickly that being brilliant and timing an entry into an investment thesis is no guarantee that her company will survive the massive bubble that has built up around her thesis. Time will tell.

In the meantime, like Tsai in the go-go '60s, Wood's success is spawning imitators...

Gary Black's résumé is impressive... Over the past few decades, he has worked for big Wall Street firms like AllianceBernstein (AB) and Goldman Sachs (GS). And he has served as the chief investment officer, the CEO, or a co-CEO of four different asset-management firms.

Black's newest company, Future Fund, launched its Future Fund Active Fund (FFND) in August...

The fund is tiny, with net assets of just $16.7 million today. But like the ARK Innovation Fund, its largest position is Tesla. And also like ARKK, Tesla accounts for about 10% of the ETF's assets.

Black told investment-analysis website MarketWatch recently that Tesla's growth will help it "grow into its valuation." And in a Twitter post on Wednesday morning, Black wrote...

I'm struck by the naïveté by seasoned investment pros who argue [Tesla] is overpriced based on current [price-to-earnings ratio]. Every finance student knows value is a function of future discounted cash flows. Those who ignore [Tesla's] 50% future expected cash flow growth as [electric-vehicle] adoption soars are idiots.

Black's hubris is palpable... He is banking on his certainty about the future of the electric-vehicle market and Tesla's expected cash-flow growth. And he says anybody who doesn't share his certainty is an idiot.

Well, I guess I'm an idiot.

According to Black, I'm an idiot for assuming that I can't predict the future... And I'm an idiot for assuming that maybe, just maybe, at $1 trillion – more than the next dozen car companies combined – Tesla's current market valuation is a tad overdone.

But under Black's logic, he's not an idiot for making Tesla his largest position because he knows how the future will look... And he knows that the competition Tesla now faces from several other major carmakers won't hurt its "50% expected future cash flow growth."

Black's unflagging confidence in an investment thesis that depends on his ability to predict the future – and its second-order effect on Tesla – reminds me of the hubris implied in Forbes' description of attitudes toward the Nifty Fifty stocks... "You can pay any price you want because inexorable growth will bail you out."

That assumption didn't work well back then... And I'm certain it won't work now, either.

Since FFND began trading on August 24, it's down about 7%. On a positive note for Black, it's beating the roughly 23% drop in ARKK over that span... But it's trailing the returns of the S&P 500 and the Nasdaq since both indexes are roughly unchanged in that period.

That's because ARKK is a pure vehicle for the bubbliest stocks. On the other hand, FFND includes some stodgy names – like Harley-Davidson (HOG), Nike (NKE), and Chipotle Mexican Grill (CMG). Besides Tesla, the only companies in both ETFs are Spotify Technology (SPOT), Square (SQ), and DocuSign (DOCU). FFND holds 35 equities to ARKK's 44.

Given the small size of FFND, a substantial downturn in Tesla or any of the ETF's other large holdings could cause mass redemptions... And that could possibly put Black out of business.

At about $21 billion in net asset value, ARKK has much more cushion to weather a crash in innovation-focused stocks... So if nothing else, at least Wood has that going for her.

In the end, Wood and Black – and their respective endeavors – are a lot like Mafia buddies to me...

I've really tried to stop being so bearish all the time. Here in the Digest over the past year, I've even channeled my inner market bull on occasion...

However, just like Michael Corleone in The Godfather Part III, I keep getting pulled back in.

Of course, there's a lot less extortion and murder in being a bearish value investor than in being a Mafia don... But you get the gist.

Who knows, maybe I'll escape the bearish life one day... But not until stocks are a lot more attractively priced – and there's no telling how long that will take...

Examples of speculative excess in the markets keep throwing themselves in front of me. So I have no choice but to keep warning you about what will happen if you're not careful.

Just don't call me Don Dan... or you might be "sleeping with the fishes" before long.

New 52-week highs (as of 12/2/21): iShares U.S. Home Construction Fund (ITB), Lennar (LEN), Lynas Rare Earths (LYSDY), NVR (NVR), Telekomunikasi Indonesia (TLK), and Trex (TREX).

A subscriber shares his thoughts on Kim Iskyan's Thursday Digest about the "masterclass in the importance of understanding what you're investing in" when it comes to Elizabeth Holmes and Theranos. Tell us what's on your mind at feedback@stansberryresearch.com.

"I agree with all points in this critique of Theranos. A lot of due diligence was NOT needed to cast considerable doubt on Holmes' claims (I know, Monday Morning Quarterbacking).

"First, anybody who has any experience in the blood-testing field will know for a fact that finger stick blood, regardless of the volume, will NOT be equivalent to venous blood samples for most blood tests. There is a reason why the only commonly used finger stick blood test to this day is the glucose test.

"A cursory look at Holmes' original patent application for a device that can diagnose abnormalities in the body via some sort of sampling through the skin and then deliver (also through the skin) the needed treatment drugs – anything like this is fine at the level of a young child in wonderland after reading some comic serial or watching Star Trek. That she even got the patent application through the system shows how broken our patent system is.

"If Holmes was writing science fiction, that would be great.

"Unfortunately, too many otherwise sane people drank the Kool Aid. Holmes belongs in jail just like [Bernie] Madoff was consigned to jail." – Paid-up subscriber Alvin M.

Good investing,

Dan Ferris
Eagle Point, Oregon
December 3, 2021