I’ve been thinking a lot about this thread between Cathie Wood and Elon, and inflation in general. Elon Musk asked Cathie, the CEO of ARK the below question:

Her response thread was pretty interesting.

I respect Cathie and her company, but have mentioned before my worries on the ARK’s risk cluster. I also don’t entirely agree with her thesis on deflation.

Cathie’s thesis seems to be that the stock market isn’t that expensive now (compared to the early 1900s) because of the deflationary impact of technology. Because of that, supports current valuations, and gives the market more room to run.

Click below to read her whole thread if you would like. I don’t have every tweet included.

> GDP statistics evolved during the Industrial Age and do not seem to be keeping up with the digital age.

Cathie is saying that both real GDP growth and inflation are mismeasured. Because of this, things are actually better than they seem to be.

Productivity, which is referenced as a driving force for economic growth, is equal to the ratio between output volume and input volume - so how efficiently labor and capital are used to produce something.

She states that GDP growth is higher than expected and inflation is lower - which doesn’t make a ton of sense (how can you get more for less or less for more, and numbers not capture that?) But if we do have increased productive capacity, she is right - that raises potential GDP and can have a deflationary impact.

So how do we measure productivity - a few different ways:

According to data from BLS, productivity hasn’t increased (on paper).

But Cathie’s thesis is that things are actually different - that all of the above are potentially not the correct way to measure productivity. A big driver behind her argument is that earnings quality has improved - that GDP stats aren’t capturing the fact that companies are better.

You can look at earnings quality from a few different angles:

Does this mean that companies getting more productive? Maybe.

But the flows towards unproductive assets (pre-revenue SPACs, potentially some of the meme stocks, and other stagnant goods) more shows that there is just a lot of money around right now. This isn’t a bad thing - but just because earnings have increased doesn’t mean that they are all going towards productive assets.

This is a big part of the narrative. Good deflation is supported by tech, and tech inherently is deflationary. That is true.

She came back a few days later to explain some of the “good vs bad deflation” and references the S&P / US GDP as a source for anchoring market valuations.

Here is what she is referring to:

The whole thesis is that the market is underpricing growth right now, relative to history. The idea is that the market was more expensive in the late 1800s and early 1900s (2-3x higher) so the market today has more upside. This is bizarre.

I think she means that we are in a similar space now - and that equities have more room to run because of that (go 2-3x higher).

There are some parallels that she draws between now and then - the Roaring 20s was fueled by technology-enabled platforms, primarily:

She cites learning curves (the infamous Wright’s law) as creating the deflationary impact (tech makes things cheaper), coupled with the gold standard.

The idea is that deflation leveled the nominal GDP, with general growth and productivity boosting the quality of earnings. Add in low interest rates = companies have a higher market cap.

Today, we have more tech (the deflationary forces and the learning curve):

She also refers to Bitcoin as today’s gold standard. So things are similar to the 1800s, 1900s - but the stock market is lower now, so there is more room to the upside.

Seems like we are already there.

The theory is that people will not spend, because they expect prices to fall. The only inflation that we would see would be in asset prices. I am not sure if this theory entirely holds up - velocity is already so low.

I don’t think we are in a world where tech allows us to wait. There are so many products, service, etc released instanteously - waiting cost is outweighed by FOMO.

Overall, I see what she is saying. I have immense respect. But I think it’s tough to compare now to the early 1900s, and say that equity markets are cheap relative to then.

It was a completely different time. For 4 main reasons (MarketDog has a good recap):

She highlights at the end that

And she is right. Markets are forward looking, but they have a memory. I think the argument of deflation is interesting - primarily because of all the short-term inflationary pressures that take precedence to the long term deflationary impacts.

I don’t know (a terrific conclusion).

I am writing this because I think we have inflationary pressures - the long end of the curve is pricing in an expectation of inflation and the expectation of tightening. But I also agree with Cathie that there are longer term deflationary forces that will price out some of the short term inflationary pressures.

The CPI is set for today at ~2.5% expected for Headline CPI and 1.5% for Core. A lot of the gap between the two is driven by increased energy prices.

US Producer Price Index climbed 1% on a seasonally adjusted basis in March (~12% annualized)

Stimulus and pent-up demand

Jump in the 10Y: It’s calmed down quite a bit, but the pace of the move upward was concerning. It shows that the market is expecting inflation (or at least doesn’t trust the Fed as much as it used to).

Asset Inflation: The stock market seems expensive. Home prices are on an absolute rip.

The Dual Mandate: Unemployment and Inflation

Part of the reason that the Fed hasn’t pulled back on QE is because there is still a real economic gap in employment - all the numbers are skewed because of the pandemic.

Things have to normalize (whatever that means) before we can get a true

sense of what things mean. Even if we do have outsized inflation, we still have to reach the Fed’s target - which will take some time. That is a whole other can of worms to unpack.

There are broader macro risks that can send the market into a tailspin - and that will create outsized pressure that the Fed won’t be able to maintain.

Leverage (looking at you, Archegos). Consumers are also trading with incredible margin - which is concerning for if/when the market does pull back

Concentration risk: This is my main problem with ARK (circling back to Cathie). I wrote about it a little bit in my Stonks piece, and I have some quick videos on it (here and here). There is illiquidity, volatility, intercorrelation, just general reflexivity from fund flows. That creates an ARK bubble, which is going to be painful if it pops.

In conclusion, I am uncertain. A lot of market movement is expectations and companies that can play into growth opportunities (tech companies as highlighted by Cathie’s thread) are going to price based off expectations, not so much current fundamentals.

Tech is deflationary. But supply chain risks are inflationary. In the long term, I think we will experience deflation as tech will expedite so many processes and create so many efficiencies - but in the short term, it does seem like that there are inflationary headwinds that the Fed and other policymakers could be underpricing.

What to do? $SPY