Quarterly Report #20: Period to 30 June 2021

QUARTERLY REPORT #20: PERIOD TO 30 JUNE 20211

Performance and net asset value2

Quarterly gross portfolio return: (6.2%); fiscal year gross return +33.6%

Our portfolio has tended to react inverselyto short term movements in markets over the quarter, doing well in May but less so in April and June when stocks were stronger. In turn, this reflects our exposures to more esoteric securities which - with some exceptions - have generally been exposed to the "value/reopening" end of the spectrum, which has lagged over the past quarter (eg. Dow Jones Industrial Average +4.6% versus NASDAQ100 +9.5%) and especially over the past six weeks since 13 May. The quarter really encompassed three periods:

• End March to early May 2021 when indices rose steadily;
• a very shaky period in the first two weeks of May culminating in a sell off around the release of the US April CPI and moves in ten year bond rates up to 1.7%; and
• a calming final six weeks when the extremely bearish sentiment and positioning in respect of US bonds was unwound - the yield falling from 1.7% to 1.48% at June month end - which resulted in some astonishing rebounds in growth/momentum/technology stocks.

Three examples from our short-sale portfolio show the extent of these extreme - and in two cases detrimental - moves in "high-growth" stocks, as the bearishness in bond markets unwound:

• Afterpay (ASX: APT) which ended March at $101.50, rose to over $127 by mid-April, fell back to a low of $84.50 on 13 May and then rallied ~40% to $118 by quarter end; we profitably covered our short in the low $90's;
• ARK Innovation ETF (ARKK) started the quarter at $120, rose to $128 by late April, collapsed to $99.50 in 12 trading days to 13 May and then ascended virtually unchecked by 31% to $131 by end quarter as its underlying investments rose; and
• Trupanion (TRUP), the pet insurer, started the quarter at $76, meandered around to $75 by 13 May, showing no reaction to a first quarter result with widening losses, then rose 53% to $115 in six weeks.

Hence, in June, all five of our worst contributors were short positions in bouncing growth stocks. To assist in your understanding of why we short sell some of these companies, this report features a lengthy assessment of Sezzle, an ASX listed BNPL operator based in the USA.

Under these circumstances, such abrupt moves aren't usually replicated in "value" stocks. An excellent example is the Norwegian company, Treasure ASA, whose only asset is some cash and a holding in Hyundai Glovis. Its shares are down 4.3% over the quarter, whilst Glovis has risen 11.5%; as a consequence, the discount to NAV is now over 45%.

1. Readers are referred to footnotes 2 and 33 - 38 explaining the derivation of the numbers. All returns are pre-tax unless stated otherwise. At the current level of net assets, cost imposition is estimated at 0.9% per month over the course of a full year (excluding capital raising related expenses) and is fully accrued monthly according to the best estimates of management. Readers are explicitly referred to the disclaimer on page 22.
2. Month by month tabulation of investment return and exposures is given on page 21, along with exposure metrics.

EAST 72 HOLDINGS LIMITED	ABN 85 099 912 044
Level 12, 95 Pitt Street, SYDNEY NSW 2000	telephone: [phone]

All in, when it's as good as it gets?

My belief that this is close to "as good as it gets" for equities and that folks are "all in" is growing in conviction.

In the past quarter, the S&P500 rose 8.2% and has gained 14% in the first six months of CY21; the NASDAQ 100 increased 9.5% in Q2 and is up 12.5% for the year. However, the erratic manner of equity performance in the June quarter perhaps offers some portends as to how markets may "correct".

Anyone looking at co-incident indicators would be surprised at our caution. We are about to enter a quarterly reporting period in the US which will be the strongest quarter of earnings growth (64%) since Q4 20093. Of course, there is an enormous "base effect" from the worst period of COVID in 2020, but S&P500 CY21 earnings in the US - which have been the subject of consistent upgrades through 2021 - are currently forecast at 191, compared to 163 in CY20194. It should be acknowledged that I have been too cynical about this progression.

Moreover, the world is opening apace - apart from Australia and New Zealand where strategic errors of COVID vaccine ordering and roll-out schemes are crimping growth and consumer confidence; the fact Australia seems to have splintered into 8 separate countries and has a Federal election due in ten months is an additional burden.

It's hardly surprising people's psychological state is improving around the world, but the manner in which has been manifested in financial markets in the past six weeks is quite stunning. Everyone's a buyer of everything - bonds, oil, stocks, property and even bottom fishing in crypto. Consider these two charts from Bank of America Global Investment Strategy showing the magnitude of first half of CY21 inflows to equity funds against prior first halves - and the outstripping of the past twenty years first halves over the past six months:

The sheer quantum of money directed at equities when fixed interest yields nothing is no surprise; never in living memory have we seen the spigots of monetary and fiscal policy so open, at the same time.

• Factset
  4 ibid

M2 money supply in the USA grew 24% during 2020 and is still rattling along at a 13% year over year rate at end May 20215. US total public debt as a percentage of GDP recently scaled a record high 135% - over four TIMES the level of 1980 and twice the level of 20086.

Trying to understand Fed policy is now extremely difficult. The latest June unemployment figures in the US show that the unemployed PLUS those "marginally attached to the labor force" now constitute 9.8% of the overall labour force; the recent low in December 2019 was 6.8% and the last time we were at these figures (on the way down) was May 2016. In May 2016, the 2 year bond yield was 0.9% against the current 0.26%; 10 year Treasury yields were around 1.8% - roughly where they got to at worst this year, and 35bp above where they are now.

Don't forget, as employment recovered further, 10year yields rose to over 3% in November 2018. The manner in which markets respond to minute changes in yields, shown in the past quarter (both ways) is most concerning, and suggests the Federal Reserve Board, and most other central banks, are trapped at these low rates and requisite bond purchases. Federal debt held by Federal Reserve banks7 now equates to over 24% of US GDP; in 2008, at the depths of recession, it was just over 3%. These simple figures show we truly are in the craziest, Frankenstein monetary experiment ever. No-one alive has ever seen this. However, there is an increasing sense and foreboding that it is coming to a conclusion, when the consequences seem frightening.

When money is so freely available - and free - past history suggests it leads to permissive behaviour. This is manifested in different ways. Record numbers of IPOs, belief that the majority of "new technology" will automatically yield very high long term excess returns, junk bonds that will not default (spreads versus Treasuries now at 3% akin to mid-2007), that you can just buy assets at any prices to "set and forget" (notably housing, selected blue chip stocks8) or that anyone can make short term returns out of equities from trading and playing - as the access to stockmarkets, or their derivatives is easier than ever via Robinhood and commission free trading.

Source: Charles Schwab & Co

• Federal Reserve Board of St. Louis "FRED" data
  6 ibid
  7 ibid
  8 If ever you are going to read John Brookes "the Go-Go Years", please do it now

Retail investor interest in markets - particularly via options as shown in the chart above - reached absurd levels in Q1CY21; after fading, it continued again from mid-May 2021, suggesting the recent rally in tech stocks and growth equities to have less than solid foundations. Recent indications (put/call options ratios, for example) suggest it may again be rolling over.

Speculating in call options - the right but not obligation to buy a security within a defined timeframe in the future at a fixed price - was a key feature of the "meme" stock movement (GameStop, AMC Entertainment etc9) and correlates very highly with the performance of technology companies which are NOT profitable. These are the types of companies which may have a business plan - usually flawed - which they have to continually sell to investors to raise new capital. These are the type of stocks which cratered 80%+ in the "tech wreck" of 2000-2003.

We also note that US index performance has been becoming thinner, with the wider market starting to underperform the larger indices such as S&P500 and NASDAQ 100 (22% and 41% FAAMG10 respectively).

RUT versus SPX

(30/6/2016 = 100)

120
110
100
90
80
70
60
-16	-17	-18	-19	-20	-21
-Jun	-Jun	-Jun	-Jun	-Jun	-Jun
30	30	30	30	30	30

The Russell 2000 (RUT) is a highly diverse index comprised of that number of smaller companies; the largest weighting of an individual company is currently 0.72% (the meme stock AMC Entertainment) with an average market value of $1.85billion (median $1.15billion).

East 72 has increasingly used RUT as a hedging mechanism in tandem with S&P500, since we don't end up (unwittingly) shorting large scale technology companies in volume. RUT outperformed the S&P500 by over 40% from the market bottom in March 2020; recent indications suggest such performance is starting to rollover. We are circumspect in our use of RUT given its much greater daily volatility compared to S&P500.

The Bank of America Global Investment Strategy survey suggest private client investors are "all- in" to equities, which would line up with some of the traits observed above; of course, this is a rather useful contrarian indicator (over time) suggesting these folks historically buy high, sell low.

So where might the problems emerge now everyone is as long equities as they have ever been?

• The Bendon/Naked Brands article "How a Reddit army brought an Aussie lingerie icon back from the dead" (AFR 2 July 2021) is a brilliant read in this area.

10 Facebook, Apple, Amazon, Microsoft, Alphabet (Google)

The past six weeks has once again reinforced the interest rate sensitivity within equity markets. With a clear belief amongst many that low rates - at both the short and longer end of the interest rate curve - are here to stay, what might change that and create greater issues? The obvious answer is unforeseen inflation or a belief that inflation currently perceived as transitory becomes more permanent.

There are obvious pockets of "demand pull" inflation, with increased demand coming out of a pandemic where supply is restricted. This can be seen in vehicle prices, which for new cars are up 15% in the USA in June over the corresponding 2020 month. The inflation rate for cars is likely to subside once supply comes back on stream, which in turn is related to increasing the level of semi-conductor production in Taiwan - as their drought and COVID cases subside. (so whoever thought that the price of your used car was going to be a function of Taipei's weather?)

The biggest area of demand pull inflation, which is yet to show up in the CPI numbers for the US (or Australia) is housing. This is partly a function of changed collection methods due to COVID and the use of "imputed rent" in the US statistics which capture asset price inflation within the housing market - but with a lag. In total, housing accounts for 32% of US CPI figures.

The other side of inflation is "cost push" where a third party influence on inputs impacts the cost of a good. The clear one at present is freight rates which have risen dramatically, particularly on the China-West Coast US route. The cost of shifting the average FEU11 has risen from just under US$1,800 to $6,300 from end June 2020 to now. Moving the same container from China to Northern Europe has doubled to over $11,350 over the past twelve months. That, of course, assumes you can GET a container. The combination of vessels out of service for ISO 2020 refits, port blockages from undermanning due to COVID and profit maximisation as demand skyrockets is fuelling these amazing moves. There are small signs at both the China and Los Angeles ends that ports are freeing up a little. But these moves are still to feed through to the consumer.

The biggest aspect to fuelling inflation is expectations. As we know from the 1970's and 1980's, once inflation expectations rise, getting this genie back in the bottle is very difficult. Why? Because people start to build it into their daily lives, and begin to combat the problem: putting up prices at their outlets ahead of time, demanding higher wage rises (at a time of seeming labour shortages). Folks are very sensitive to higher fuel prices, which (of course) economists try to detract from the CPI figures: they are transparent and easily observable.

If inflation expectations break out, we know in the Australian context how difficult it is to quell them. Our last major bout of inflation subsided in the mid-late 1990's after the Hawke/Keating/ACTU "Accord", an eventuality unlikely to be repeatable. In the US, it took Volker's sky-high interest rates and a recession to do so. The current economic situation has increasing challenged the narrative that 'deflation" is an ongoing phenomenon, given that oligopolies around the world appear to dominate selected industries ranging from "streaming" to iron ore to specialist computer chips to search. Service industries, with their key inputs of "people" are not immune.

With long bond rates below 1.5%, credit spreads close to very cyclical historic lows, in this type of world, with numerous aggressive cost-push influences, the chance of bond market dislocation from here appears more likely, especially after investors have now moved away from their extreme bearishness of only a few weeks ago.

11 Fourty-foot equivalent unit container