ARKX: Bears Are Still In Control (BATS:ARKX)

Investment Thesis

Despite being down roughly 30% over the last 12 months, the ARK Space Exploration & Innovation ETF (BATS:ARKX) is still a great short for several reasons. First, the short interest in ARKX is relatively low, meaning that there are fewer investors betting against the stock. Second, constituents that are profitable trade at high valuations, which I believe will ultimately prove unsustainable given that the Federal Reserve is currently withdrawing liquidity from the market. Finally, market positioning in ARKX is still relatively bullish and far from indicating capitulation, which suggests that there is still room for the stock to decline. Overall, these factors make ARKX a compelling short opportunity.

About ARKX

ARKX is an actively managed exchange-traded fund that invests in companies that are involved in the development and exploration of space technology. This can include companies involved in satellite manufacturing and launch services, as well as companies working on developing new technologies related to space travel and exploration. The ETF’s objective is to provide investors with exposure to the growth potential of the space industry, which is expected to experience significant growth in the coming years as more countries and private companies invest in space-related technologies.

The ARK Funds Narrative

The ARKX ETF is one of a number of thematic ETFs offered by ARK Investment Management, which also includes funds focused on areas such as genomics, electric vehicles, and fintech. These funds allow investors to gain exposure to innovative and disruptive trends in a cost-effective and diversified manner.

For the past 3 years, Cathie Wood, founder, CEO, and Chief Investment Officer of ARK Investment Management has become a well-respected and influential figure in the investment industry, known for her forward-thinking and innovative approach to investing. Media outlets have praised her ability to identify and invest in companies in the technology sector, including companies focused on areas such as genomics, artificial intelligence, and electric vehicles.

Shorting ARKX Is Still A Profitable Trade

Below are the three main reasons why I think that shorting ARKX is still a good trade, despite the fund being down nearly 30% compared to 12 months ago:

Low short interest

ARKX has a low short interest of 3.1%, compared to a short interest of 12.4% for ARKK. Low short interest is a good thing when you want to short a stock because it suggests that there are fewer investors betting against it. This generally leads to less aggressive rallies, since there is less short covering during temporary bottoms. Being involved in a crowded trade can lead to increased volatility in the market and make it more difficult to exit the trade if you need to, while the opposite generally holds true with less popular trades. This can create a more favorable environment for short sellers and make it easier to profit from a potential price decline.

High Valuations While Rates Will Stay Higher For Longer

This is probably a recurring argument by now, but it still holds true. We are nowhere near a pivot in my opinion in terms of monetary policy and the Fed Funds Rate will probably reach ~5% in 2023, making the impact of this tightening cycle even more negative for equities.

Most stocks in the ARKX portfolio are perceived and more importantly, valued, by market participants as tech stocks. According to Morningstar, ARKX has an average P/E ratio of 26, with a handful of names that are burning cash at the moment. Below is an overview of ARKX’s top 10 holdings:

Tech stocks with high valuations tend to perform poorly during monetary policy tightening cycles. During these periods, investors tend to shift their focus away from riskier investments such as tech stocks, and towards safer investments. Tech stocks with high valuations are particularly vulnerable to this trend because they are often valued based on their growth potential rather than their current earnings. When economic conditions deteriorate, investors become less willing to pay a premium for future growth and instead opt for cash-flow positive investments.

Policymakers have made it clear that rates are about to stay higher for longer. I personally tend to believe that the Fed will hike rates up to ~5%, which doesn’t bode well for long-duration assets like tech stocks. At the same time, the Fed is reducing its balance sheet by $90 billion a month since September 1st, 2022, tightening further financial conditions in the economy.

Market Positioning Is Still Bullish: Sell To Optimists, Buy From Pessimists

The market positioning relative to Cathie Wood and her funds remains overall bullish. The ARK Innovation ETF (ARKK) registered positive net flows as illustrated by the growth in current shares outstanding. I believe that the positive fund flows into ARKK can partially be attributed to the “buy the dip” mentality among investors, which remains extremely resilient despite ARKK’s recent negative returns. The “buy the dip” mentality refers to the tendency of some investors to view market declines as opportunities to buy assets at what they consider to be discounted prices, with the expectation that they will recover in the future. Overall, the positive fund flows suggest that investors remain confident in the long-term growth potential of the companies held by the fund despite recent negative returns.

In contrast to ARKK, ARKX has seen negative fund flows in recent months. This suggests that investors do not share the same level of optimism about the two strategies and are showing a preference for the more popular ARKK. Over the past 12 months, investors have withdrawn approximately $68 million from ARKX according to data from Factset, which represents a significant amount for a ~$270 million dollar ETF.

The difference in investor positioning between the two ARK Funds is intriguing, especially when you factor in the fact that ARKX has actually outperformed ARKK over the past 12 months.

I personally believe there is mounting pressure on ARK Investment Management to deliver satisfactory returns after they had to shut down their ARK Industrial Innovation ETF (CTRU) in July 2022. The closure of the CTRU ETF has raised concerns about the viability of ARK Investment Management’s thematic investing approach and has put pressure on the firm to reconsider its investment approach.

Overall, I think that investors remain supportive of Cathie Wood and her investment vision. However, it is worth noting that investor sentiment can change very quickly, particularly in a prolonged bear market. While Wood and her firm have experienced success in the past, I believe that patience is running thin, and in a scenario where returns continue to underperform the market, actual buyers are likely to turn into sellers, adding further downside pressure on the ARK ETFs.

What Are The Risks And How To Set Up The Trade

Judging by the technical aspect of the chart, the trend is pretty clear when it comes to ARKX. The stock failed to break the 200-day moving average several times over the last 12 months. This is a bearish signal in my opinion, as the stock lacks the required momentum to take it higher. On top of that, ARKX hasn’t been able to make new highs for over 9 months, which is another bearish indicator.

That being said, ARKX failed to make new lows recently when it tested the recent bottom, which is something noteworthy. At this stage, I think it’s highly likely to get another bear rally, which will temporarily squeeze shorts. Bear rallies can be vicious because they can give investors false hope that the market is recovering, and can take the stock much higher in a short time span. The solution for this is to short major rips, often 10 to 20% above the previous low.

The safest way to set up a short in ARKX is through options. Holding a long put position allows you to have an asymmetric risk-reward trade where you can only lose your premium paid for that option. I am personally looking at 18-Aug-2023 puts with a strike at $12 that currently have an implied vol of 34. Buying that option when ARKX rallies for an implied vol below 25 would seem like a great deal to me, provided you have at least 6 months to expiration.

Key Takeaways

Despite a 30% drop in the previous year, ARKX is still an excellent short for multiple reasons. First, the short interest in ARKX is low, indicating that fewer people are betting against the stock, which will accentuate drawdowns due to the lack of short covering. Second, portfolio components still trade at high valuations, which I believe will eventually prove unsustainable given the Fed’s recent withdrawal of liquidity from the market. Finally, market positioning in ARKX remains relatively optimistic and far from signaling capitulation. Overall, the combination of these elements makes ARKX an appealing short.