I founded ARK Invest for two reasons: first, to focus solely on disruptive innovation, primarily in the public equity markets, and second, to open up our research ecosystem, becoming the first ‘sharing economy’ company in the asset management space. Our original research dimensions the exponential growth associated with five major innovation platforms: DNA sequencing, robotics, energy storage, artificial intelligence, and blockchain technology. Not since the late 1800s have multiple innovation platforms evolved at the same time.
Much like in the late nineteenth century, disruptive innovation is throwing off the meaning of certain economic signals, importantly the yield curve. While equity markets today fear the impact of a ‘bearish flattening’, we believe that a ‘bullish flattening’ is under way as technologically-enabled disruptive innovation and productivity gains evolve into a ‘deflationary boom’ the likes of which we have not seen since the late 1800s. During the 50 years ended 1929, the yield curve was inverted more than half of the time as the disruptive innovation platforms of that day – the internal combustion engine, telephone, and electricity – unleashed periods of extraordinary real growth rates. The steepest inversions occurred during periods of the most rapid growth in real GDP. We would not be surprised to see this seeming ‘disconnect’ during the next few years.
How to identify transformative technology
One of the critical questions when investing in innovation is how to distinguish the innovation that will change the way the world works from that which will reset a narrow slice of the play space.
At ARK we use three qualifying criteria to filter for transformative technology. We believe transformative technologies:
- experience dramatic cost declines and trigger key unit economic thresholds.
Crossing certain cost/performance thresholds can widen and diversify end-use addressable markets dramatically. We believe many investors don’t do the work to understand these unit-economic thresholds and misunderstand the potential scope of a transformative technology.
- cut across sectors and geographies.
An innovation that can proliferate across multiple industries and countries can enjoy dramatic addressable market increases as applications are ‘discovered’ by different business sectors. Spanning across sectors also provides the opportunity for better product-market fits, insulates the innovation against business cycle risk, and garners attention from multiple disciplines, accelerating the innovation’s mutation rate. In an increasingly siloed Wall Street, with specialists for every subsector and a focus on short-term dynamics, a cross-sector transformative technology is exceedingly difficult to understand. Thus, we believe traditional Wall Street may miss the bulk of the investment opportunity.
- serve as platforms atop which additional innovations can be built.
A platform upon which other innovations can be built may expand the potential use case in ways that are almost impossible to imagine. The innovations, business models, and cultures that develop atop these innovation platforms help to weave them into society’s fabric. Innovation-spawning platforms are typically underestimated over expansive time horizons because successful forecasts require that an analyst anticipates the scope of new products and services that they will spawn.
When combined, these criteria can increase the odds that a technology will have a profound impact and can decrease the odds that incumbent companies and investors will anticipate the technology’s ultimate impact.
The equity market continues to climb the wall of worry
Concerned that the record-breaking bull run has overstayed its welcome, many strategists had highlighted the narrow leadership of the US stock market as it had bucked weakening trends elsewhere in the world. Through June, the so-called FAANG stocks had accounted for 75% of the S&P 500’s 2.64% total return, in many minds the harbinger of a bear market like that after the tech and telecom bubble. Well, the third-quarter correction, concentrated in many of the FAANGs in the US, took care of that concern.
ARK Invest has taken issue with the skittish view of equity markets around the world. Though the rolling correction around the world has raised concerns, our conviction in this bull market continues to strengthen. Indeed, based on our research and experience, I believe that the bull market did not start in earnest until late 2016, and that the innovation centres of the world are putting in place technology platforms that will extend it by creating a ‘deflationary boom’. After it hit bottom in March 2009, the S&P 500 did little but recover from disaster until March 2013 when it revisited its 2007 peak. At that point, fears of a debt-driven deflationary bust began to surface, particularly because traders and investors were unnerved that the market had peaked at the same level 13 years earlier in March 2000. March 2000, November 2007, March 2013: a triple top? Then, from 2013 through 2016, most investors were on edge as the market pushed forward but suffered through several risk-off moves, the worst of them in early 2016 when oil prices were collapsing. Culminating on election night in the US, each risk-off period added new bricks to the massive wall of worry that has been building for nearly ten years now.
The healthiest bull markets tend to climb walls of worry, with today’s bricks being cemented by concerns about a flattening yield curve in the US, trade tariffs, and geopolitical concerns. While others argue that the yield curve is flagging signs of recession, we believe that it is discounting the early stages of a deflationary boom the likes of which have not been seen since the turn of the nineteenth century. During the next few years, particularly if trade conflicts are resolved with lower tariffs globally and greater protection of intellectual property in China, we believe that real growth and profits around the world will surprise on the high side of expectations as inflation turns down and perhaps goes negative. Consequently, led by the US, short rates will continue to rise in response to strong and accelerating real growth, while long rates will be tamed by continued surprises on the low side of inflation expectations.
This explanation of the flattening yield curve seemingly suggests that ‘this time is different,’ but this time is not different in the context of technologically-enabled disruptive innovation. During the 50 years ended 1929, the last time that three or more general purpose technology platforms were evolving simultaneously, the yield curve was inverted more than half of the time.1 The disruptive innovations of that time – the internal combustion engine, telephone, and electricity – stimulated rapid real growth at low rates of inflation. Through booms and busts in an era without the Federal Reserve and with minimal government intervention, US real GDP growth averaged 3.7% and inflation 1.1%, while short rates averaged roughly 4.8% and long rates roughly 3.8%.2 The yield curve was inverted. So, this time is not different, but investors do have to extend their time horizons to understand the impact of profound technological breakthroughs on the economy.
The stock market’s position today seems polar opposite to that of 1999–2000
During the late 1990s, capital spending was in a full-fledged and extended boom, thanks to the easy money associated not only with the stock market bubble but also with the Fed’s preemptive moves to cushion the economy ahead of Y2K. Concerned that the global economy would tank as computers shut down when the calendar turned from 1999 to 2000, the Fed pushed the Fed funds rate down from 5.6% in June 1998 to 4.8% in June 1999.3 While the speculation in tech and telecom was epic during that period, less well-remembered are the excesses that took place in biotech, as companies raced to file for patents on genes, sending their stocks into orbit.
While some investors wonder why the bubble popped so abruptly on March 10, 2000, I recall two precursors. First, in late December 1999, the US and UK revised interim guidelines for patenting genes, forcing applicants to provide use cases for the genes under consideration.4 Then, before the comment period ended in March 2000, both countries signed a statement urging that raw data from the Human Genome Project be made available for free to scientists, an unexpected development given the USD 2.7 billion in costs necessary to sequence the first whole human genome.5 Adding to those controversies, in January 2000 a private citizen filed a privacy suit against DoubleClick, an online advertising agency now owned by Alphabet on behalf of the general public in California.6 In my view, that one-two punch against genomics and the Internet turned ‘more buyers than sellers’ into ‘more sellers than buyers’, particularly for growth stocks, which collapsed. Long-neglected value stocks took the baton and ran, stoked by China’s impending entry into the World Trade Organization.
Unlike their behaviour during the tech and telecom bubble, companies have not been confident enough in recent years to invest aggressively in technology, while healthcare-oriented investors have been ignoring profound breakthroughs associated with DNA sequencing. From mid-2014 through the third quarter of 2016, perhaps because of fears caused by the Fed’s tightening moves and market volatility, capital spending – as measured by real nonresidential fixed investment in the US – increased only 0.8% at an annual rate.7 As a result, according to a Ponemon Institute survey, 52% of US and EU companies were not ready to satisfy Europe’s General Data Privacy Regulation (GDPR) when it became effective in May, quite a contrast from the manic behaviour associated with Y2K.8 Not until the passage of tax reform, which included the full expensing of capital equipment in year one, did investment spending come alive. During the first half of 2018, real nonresidential fixed investment increased 9.3% at an annual rate.9
Perhaps more remarkable has been the response, or lack thereof, to potentially life-saving therapies and technologies like CRISPR-Cas9. During 1999, had analysts and portfolio managers learned of a technology that might cure the blind and those with cancer, a group of stocks with exposure to the primary CRISPR-Cas9 patents – Intellia, Editas, and CRISPR Therapeutics – probably would have scaled to a combined market cap in the hundreds of billions of dollars. Instead they have struggled to reach roughly USD 5 billion. Moreover, unlike in 1999–2000, government policies are supportive today as one of the US administration’s top priorities in healthcare is to accelerate the approval of life-saving and life-changing therapies.10 At the same time, the UK government recently disclosed that it will allow the editing of germline cells – the sperm and the egg – under certain conditions.11 The investment backdrop today couldn’t be more different from that in 1999–2000.
The tech and telecom bubble saw the future: The future is now
The tech and telecom bubble put in motion five general purpose innovation platforms that are hitting tipping points, while cutting across economic sectors and converging to spawn more innovation. As can be seen on our research website, we identify the five innovation platforms as DNA sequencing, robotics, energy storage, artificial intelligence, and blockchain technology.
Unlike the narrowly focused tech and telecom bubble which caused a capital-spending sinkhole but no killer apps, these platforms have hit price points low enough to unleash demand, create new markets, encourage experimentation, and democratise access. The cost to sequence a whole human genome, for example, has dropped from nearly USD 3 billion in 200012 to less than USD 1,000 today and, according to our research, is on its way to USD 100 in 2021. As a result, the demand for whole human DNA sequencing is beginning to explode. Industrial robot costs are heading toward USD 10,000 and a payback period of six months, giving small businesses access to productivity enhancements never before possible. 3D printing is cutting costs by up to 75% and shifting power from large manufacturers to more entrepreneurial or creative designers,13 while drones are cutting delivery costs by up to 90% and distributing medicine to remote villages in Africa and Asia. Electric vehicles will be less expensive than gas-powered vehicles in fewer than five years, and will continue to fall in price, giving more consumers the opportunity to experience 0 to 60 mph in fewer than 3 seconds and get to work for USD 0.35 per mile instead of the USD 3.50 per mile on average charged today by US taxis. Meanwhile, computing performance per dollar continues to improve at more than 40% per year, which has given birth to modern artificial intelligence, and as blockchain technology proliferates the marginal cost of money transfers likely will drop to zero. A global digital currency, over which no government has control, could become the killer app of the century.
Not only will they stimulate substantial growth and create new markets, these new platforms also will disrupt sectors which historically have stoked high inflation. Global oil demand is likely to peak within the next few years as electric vehicles begin to scale and as autonomous electric taxi networks account for an increasing share of miles travelled. DNA sequencing will introduce science to healthcare decision-making in a way never before possible, minimising the guesswork and eliminating waste which, according to some estimates, could be 40%14, with some estimates reaching as high as 50%.15 At the same time, robots will serve not only as an antidote to labour shortages that are cropping up in the US, Japan, China, and elsewhere, but also should increase productivity, one of the most powerful forces against inflation.
While the equity market may have narrowed in its focus for a time this year, the investment backdrop today bears no resemblance to the excesses that took place in the late nineties. Investors have been climbing a wall of worry since the market hit a ‘triple top’ in 2013, the Fed has been tightening, and capital spending had been moribund until recently, adding to our confidence that capital flows into disruptive innovation have been discerning, certainly in the public, if not the private, markets.
The tech and telecom bubble did see the future, perhaps 15 to 20 years too early. That future is now and, if our research is correct, the payoff will last for the next 15 to 20 years.
Addressing concerns during periods of market volatility
Given the recent move in interest rates, intensified trade tensions, and increased market volatility, I would like to share two charts which I believe offer some perspective.
Chart 1 suggests that Fed policy is not tight. Before or during past crises, the Fed has ignored signals from the three-month Treasury bill rate and tightened too much or eased too late and too little, allowing the three-month Treasury bill rate to drop 20 basis points below the Fed funds rate. Today, the Fed seems to be following the economy in setting policy, not trying to get ahead of it or to cut it off. Indeed, the Treasury bill rate is nearly 20 basis points above the Fed funds rate, higher than it has been in nearly 25 crisis-prone years.
Chart 2 suggests that, even though equities have not been in a bear market for nearly ten years, funds have not followed the market up. While cumulative bond inflows have totalled roughly USD 2 trillion, equity flows have been negative since 2008. When, we wonder, will the reallocation from bonds back to equities begin?
Mutual funds and ETFs cumulative since 2008
Another concern is that the yield curve has been flattening, something we have been anticipating thanks to strong real GDP growth – pushing short-term interest rates up – as inflation surprises on the low side of expectations thanks to technologically enabled innovation – holding long-term interest rates down. We would not be surprised to see the yield curve invert in the ‘deflationary boom’ that we are anticipating during the next few years, much like it did in the late 1800s/early 1900s, the last period during which multiple innovation platforms were evolving at the same time. During the past 50 years, inverted yield curves have been associated with recessions, so understandably investors are concerned. Based on our research, we are not concerned.
As for trade tensions, we believe that they are diminishing as the US now has deals with Mexico and Canada, our two largest trading partners, as well as South Korea, and our talks with Japan and Europe seem to be making progress. As a result, China has become somewhat isolated. During NikkoAM’s FOREWARD conference in Singapore in August, we learned that China may be willing to buy more US goods and to grant technology companies intellectual property rights but is not willing to limit subsidies to state-owned enterprises (SOEs). If so, given my experience and view of the current US administration’s position, I believe that we not only will have a deal but that it will include widespread tariff reductions as well. Another (tariff) tax cut, global in scale, would be very bullish.
As it relates to the technology sector, my experience during periods of uncertainty is that innovative companies gain significant share in tumultuous times. Their shares get hit disproportionately in the early stages of a correction because they tend not to be big index players, but they recover much faster than many of the value traps that populate the traditional indexes in which investors seek safety. A good example in 2008–10 was Salesforce.com (CRM) which was not in most broad-based indexes. Chief Technology Officers at that time were told to cut their budgets by 20 to 30% so they were forced to do things differently: they moved away from the enterprise license/maintenance model to ‘pay as you go’, the software-as-a-service model. While tech spending dropped 20%+, CRM’s worst quarter for revenue growth was +20%!16 Its stock got hit hard in the early phase of the market’s decline, but it came out flying. Truth does win out once the emotional reaction (and the race back to benchmarks) ends.
During periods of market volatility, investors should concentrate their portfolios toward their highest conviction names, as ‘babies are thrown out with the bath water’. Investors should pick up the ‘babies’.
1 Gleaned from the figures and data pulled from Bloomberg.
2 ARK Investment Management LLC, 2018; data sourced from: Bloomberg, stcentury.blogspot.com/2012/09/us-real-per-capita-gdp-from-18702001.html" target="_blank">http://socialdemocracy21stcentury.blogspot.com/2012/09/us-real-per-capita-gdp-from-18702001.html and www.armstrongeconomics.com/us-population-1776-date/ in combination were used to calculate the real GDP number; www.in2013dollars.com/inflation-rate-in-1929; www.multpl.com/10-year-treasury-rate/table/by-year.
9 Bloomberg data.
16 ARK Investment Management LLC; Data sourced from Bloomberg.
ARK's statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. For a list of all purchases and sales made by ARK for client accounts during the past year that could be considered by the SEC as recommendations, ark-invest.com/wp-content/trades/ARK_Trades.pdf. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. For full disclosures, ark-invest.com/terms-of-use.
The views expressed in this article are those of the author and may differ from the published views of Commerzbank Corporate Clients Research Department, the communication has been prepared separately of such department. No representations, guarantees or warranties are made by Commerzbank with regard to the accuracy, completeness or suitability of the data.