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The Economics of the Stock Market. 2022. Andrew Smithers. Oxford University Press. Judging by the behavior of the stock market, we are living in challenging times for mainstream finance. Under the hypothesis that markets are efficient and investors are rational, neoclassical theory assumes away the problem of financial bubbles and the linkages between equity returns and the rest of the macro variables. After a decade of unconventional monetary policies, massive fiscal deficits, and the return of inflation, however, equity market behavior in recent years has been nothing short of perplexing, leaving most practitioners struggling to understand the vagaries of stock markets. Today, the workhorse neoclassical model requires a thorough review of its assumptions (and conclusions). Now, more than ever, we urgently need a comprehensive alternative. Andrew Smithers attempts to fill in this gap with his latest book, The Economics of the Stock Market, which offers an alternative theory of how stock markets work. The book builds on a small and obscure tradition of growth models, pioneered by Nicholas Kaldor more than 50 years ago, which dealt with distributional issues in a Harrod–Domar-type framework. One of these iterations showed that in a closed economy with two sectors (households and firms) and no government activity, equity valuation multiples are determined solely by macroeconomic variables — crucially, by the equilibrium between aggregate savings and aggregate investment. Kaldor’s framework was quite novel in that stock market valuations integrated seamlessly into the macroeconomy and were responsible for balancing saving and investment, in contrast to the Keynesian and neoclassical traditions in which the equilibrium process works through quantities (unemployment rate) and prices, respectively. Although Kaldor never intended his model to be a framework for understanding stock markets, Smithers draws on this setup to articulate a theoretical alternative. Smithers is also very “Kaldorian” in the way he constructs his framework, for two reasons. First, he is primarily interested in the long-run behavior of the system, or steady-state solutions. Second, he relies on several “stylized facts” about stock markets to inform his assumptions. In particular, four variables have historically been mean-reverting to a constant, and any model should take these into consideration: Equity returns in real terms The shares of profits (after depreciation) and labor in total output The ratio of interest payments to profits The ratio of the value of fixed capital to output (a Leontief-type production function) The first stylized fact has particular relevance to the mechanics of the overall model. For Smithers, equity returns (in real terms) are mean-reverting and tend toward a constant in the long run, at about 6.7% per annum. According to the author, this long-run constant results from capital owners’ risk aversion rather than from the marginal productivity of capital or from households’ consumption decisions. As we shall see, this dynamic has profound implications for determining returns in other asset classes. This novelty is not the only one in Smithers’s framework. His model varies from the neoclassical framework in at least three other ways. First, at the heart of Smithers’s proposal is the firm as a separate entity from households. This distinction is important because firms behave significantly differently from households. For firms, decisions on investment, dividend policy, share issuance, and leverage are made by managers whose motivation (keeping their jobs) differs substantially from that of the neoclassical utility-maximizing consumer. In Smithers’s framework, firms do not seek to maximize profits, because if they did, they would vary their investments with the cost of capital — as in investment models based on the Q ratio. Casual empirical observation appears to confirm this point — as Smithers explains, “Rises in the stock market would be constrained by a growing flood of new issues as share prices rise and their falls would be limited by their absence in weak markets. Smaller fluctuations in the stock market would seem naturally to follow.” In this respect, any model should also consider the contrasting behavior of listed and unlisted companies. According to Smithers, one consequence of more companies being listed is that the corporate sector as a whole becomes less responsive to the cost of equity (Q models). This dynamic occurs because when it comes to investment decisions, management teams’ behavior is constrained by the possibility of a hostile takeover and job loss. In other words, “managements are concerned with the price of their companies’ shares, rather than the overall level of the stock market.” One macroeconomic implication of the absence of a link between valuations and investment is that the stock market plays an important role in economic growth, by preventing fluctuations in the cost of capital from affecting the level of investment — and ultimately output. Second, the returns among asset classes are derived in an independent fashion and are not codetermined. In Smithers’s framework, a firm’s balance sheet is assumed to consist of short-term debt (which can be thought of as very liquid instruments), long-term bonds, and equity. These instruments’ returns are derived independently, and their influences on the system work through different mechanisms. Savings and investment are equated by movements in the short-term interest rate. Corporate leverage is balanced with the preferences of the owners of financial assets through variations in bond yields. Finally, as explained earlier, equity returns are stationary. Consequently, the difference in returns among asset classes — that is, the equity risk premium — is not mean reverting, it has not historically had a stable average, and its level cannot provide any information about future returns for either equities or bonds. For Smithers, the equity risk premium is a residual and bears little relationship to the role it plays in mainstream finance. Finally, for Smithers the cost of capital varies with leverage at the macroeconomic level. This conclusion diametrically opposes the 1958 Miller–Modigliani Theorem (M&M), which states that the value of a firm is independent of its capital structure. According to M&M, a firm’s risk increases with its financial leverage, so the required return on equity increases with it, leaving the overall cost of capital unchanged because debt is

As corporate collapses continue to catch stakeholders off guard, analysts face growing pressure to dig deeper than traditional audits allow. The limitations of standard financial reporting — especially in identifying “going concern” risks — have exposed systemic blind spots in evaluating a company’s true financial stability. For those involved in mergers and acquisitions (M&A), private equity (PE), or strategic planning, Quality of Earnings (QofE) analysis has become an indispensable tool. It helps surface red flags, validate financial performance, and provide a more reliable foundation for investment decisions. In this post, I will highlight why this topic is important and detail the components of QofE analysis. Why Is Quality of Earnings (QofE) Analysis Critical? Research from the Audit Reform Lab at the University of Sheffield found that auditors failed to identify material uncertainties related to going concern in 75% of significant corporate failures in the UK from 2010 to 2022. The Big Four auditing firms – Ernst & Young (EY), PricewaterhouseCoopers (PwC), Deloitte & Touche, and KPMG — provided going-concern warnings in less than 40% of situations, while smaller firms had an even more disappointing warning rate of 17%. Several high-profile cases have highlighted audit failures which reveal significant deficiencies in the auditing industry. For example, KPMG came under scrutiny for its audits of Carillion, a UK construction and facilities management company that collapsed in 2018. The Financial Reporting Council (FRC) imposed a £21million fine on KPMG for its role in the audit failures, citing serious shortcomings in the firm’s work. Similarly, EY has faced investigations related to its audits of Wirecard, a German payment processing company that fell into a massive fraud scandal. PwC has also encountered several major controversies, including a six-month ban in China for audit failures linked to the collapse of Evergrande.  While an audit report confirms that historical financial statements adhere to generally accepted accounting principles (GAAP), it does not always accurately reflect a business’s true earnings capacity. The QofE process goes beyond GAAP by adjusting for non-recurring items, normalizing revenue streams, and establishing a reliable baseline for projections and valuations. Image Source: Author Analysis While the scope of a QofE report is not strictly defined, and determining the quality of earnings can be challenging, there are three key factors that should be addressed in any QofE analysis. They are: Financial performance analysis, Proof of cash (PoC), and Net working capital (NWC) Financial Performance Analysis The revenue mix in the QofE report can sometimes highlight customer concentration as a significant risk factor. A high reliance on only a few key customers exposes the business to revenue volatility if those customers decrease their demand or terminate contracts. This concentration can lead to scenarios where the financial health of the business is heavily tied to the performance and longevity of a limited number of clients.  Furthermore, the geographical distribution of the customer base introduces different levels of risk. For example, global customers are influenced by a range of factors, including local supply and demand dynamics, economic conditions, political stability, regulatory changes, and exchange rate fluctuations. These external forces can greatly impact customers’ purchasing behavior, which, in turn, affects the company’s revenue stability.  Other areas of investigation include: Image Source: Author Analysis Proof of Cash The proof of cash (PoC) test is a critical factor in QofE analysis, offering a detailed reconciliation of cash inflows and outflows to ensure the integrity of reported financial performance. This test links the company’s reported cash transactions to its bank statements, thereby validating that the financial data aligns with actual cash movements. It helps detect discrepancies that could indicate errors, fraudulent activity, or mismanagement. The PoC test ensures the accuracy of key financial metrics like revenue, expenses, and EBITDA, which are central to a transaction’s valuation. By reconciling transactions, the test verifies that: Revenue is not overstated (e.g., uncollected sales not reflected in cash inflows). Expenses are complete and accurate and have proper cash documentation. There are no unrecorded liabilities or unusual cash activities like large transfers to related parties. The PoC test relies on three primary data sources: Bank statements: Detailed records of all cash inflows and outflows over a specific period, typically covering several months or years. General ledger entries: The company’s official record of transactions, used to match reported figures with actual cash movements. Source documents: Supporting documentation for major transactions including invoices, receipts, contracts, and payment confirmations. Net Working Capital Net working capital (NWC) is an important aspect of QofE analysis because it indicates a business’s liquidity and operational efficiency. In a QofE assessment, NWC is evaluated to ensure that the company maintains sustainable working capital levels that enable it to support ongoing operations and meet its short-term obligations without relying on external financing. NWC is calculated as the difference between current assets (receivables, inventory, etc. ) and current liabilities (payables, accrued expenses, etc.). NWC is important for QofE for many reasons including: Sustainability of operations: By analyzing trends in NWC, analysts can assess whether a company’s operational cash flow is stable and sufficient to support normal business activities after a transaction. Adjustment of purchase price:NWC is crucial for establishing what constitutes a “normal” level of working capital for the business. Deviations from this standard may lead to adjustments in the purchase price during M&A transactions, ensuring that neither party assumes undue risk. A thorough review of NWC can reveal several risks, including these: Volatility in working capital fluctuations may indicate operational inefficiencies, seasonal patterns, or poor cash flow management. Revenue recognition risks: Unusually high accounts receivable might suggest overly aggressive revenue recognition practices. Inventory concerns: Excessive or obsolete inventory may artificially inflate current assets. Liability mismatches: Large, unrecorded, or unusual current liabilities can indicate hidden risks or mismanagement. Operational insights: Analyzing NWC often uncovers underlying issues such as customer concentration risks, supplier payment delays, or inventory turnover trends. These factors can significantly affect a company’s valuation and operational viability. While evaluating NWC is crucial, it is equally important to estimate the cash requirements needed to support working capital for the first 30

The Ongoing Influence of Fed Intervention The markets responded immediately when the US Federal Reserve announced it would intervene in corporate credit markets to bolster the economy amid the pandemic outbreak. Swift central bank action combined with fiscal stimulus drove an incredible economic rebound and a massive rally in risk assets that sent credit spreads back to pre-COVID-19 levels by year-end 2020. Still, the low spreads in late 2020 and throughout much of 2021 were not unprecedented. Similar spreads preceded both the pandemic and the global financial crisis (GFC) without COVID-19-levels of monetary and fiscal support. Spread volatility tells a similar story. As the figure below demonstrates, spread volatility in the United States decreased significantly from its peak during the March 2020 selloff. But the low volatility post-pandemic was well within historical norms and did not signal a regime change. Post-Pandemic Spreads Are Not Unprecedented As of 31 December 2021Source: ICE data Unlike their European counterparts, US investment-grade month-end spreads widened to within 20 basis points (bps) of the fair value model’s estimates in March 2020. By late March 2020, the Fed had announced its corporate bond purchases and the market had begun to recoup its losses. To be sure, any model that anticipates something as complicated as compensation for credit risk should be treated with caution. Yet even as the European Central Bank (ECB) reactivated its corporate sector purchase programme (CSPP) before the pandemic, European credit spreads did not follow the model like their US counterparts. And Neither Are Volatility Spreads As of 31 December 2022Sources: ICE data and MacKay Shields Credit Spread Model Suggests Credit Is Fairly Priced As of 30 June 2022Source: UBS But what about the options markets? Do they offer any insight into the existence of a “Fed put” in US credit markets? After all, if investors anticipate less volatility in the future and smaller losses during stress events, then downside protection in options markets should be cheaper. The following figures visualize the implied spread widening from CDX IG 3m 25d Payer swaptions compared with periods when actual CDX spreads increased by more than 50 bps. As credit spreads grew, the cost of protection rose. Since the last major credit market drawdown in 2020, volatility and the cost of protection had both stabilized. That is, until recently. Indeed, we may be on the cusp of a major stress event. The macro picture is evolving, inflation remains a concern, and some indicators suggest an approaching recession. As credit spreads widen, the coming months may reveal quite a bit about market expectations around central bank interventions. “Fed Put” Not Yet Reflected in the Cost of Insurance As of 29 July 2022.Shaded area represents widening of spreads.Sources: Bloomberg, Goldman Sachs, and MacKay Shields. Legal and Political Context The Federal Reserve Act defines what lending activities the central bank can engage in, and in Section 14 it outlines what sorts of financial assets it can buy. Corporate bonds are not among the securities Federal Reserve banks are allowed to purchase in the secondary market. But the Fed has worked around this by applying its broader lending powers. Specifically, the Fed can lend to a facility that it creates, which can then purchase assets with those funds. The Fed used this technique during the GFC, including for the Commercial Paper Funding Facility (CPFF). All the Fed’s lending activities must be “secured to [its] satisfaction,” and the assets in the facility should, in theory, serve as collateral. But since the facility will only fail to return loaned funds to the Fed if the assets do not perform, they do not constitute adequate collateral. Thus, in each of the two pandemic response facilities — the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF) — funds provided by Congress under the CARES Act served as a first-loss equity investment. In protecting the Fed from losses, these investments ensured the central bank was secured to its satisfaction. Since the Fed established the two corporate credit facilities shortly before the CARES Act became law, the 23 March 2020 announcement noted that Treasury would use funds from the Exchange Stabilization Fund (ESF) to provide equity for the facilities. In contrast to these explicit first-loss investments in Federal Reserve facilities, the Treasury backstop of the CPFF during the GFC was less formal. Under the time pressure of the Lehman Brothers default and the subsequent run on money funds, and absent clear precedent, the Treasury simply announced a deposit at the Fed with money from the ESF as an implicit first-loss contribution to the CPFF. Section 13, Paragraph 3, of the Federal Reserve Act limits Fed lending to “unusual and exigent circumstances,” or during financial market crises and other periods of stress. These conditions applied to the PMCCF, which was intended as an alternative source of funds for corporations that couldn’t borrow from banks or in credit markets. These conditions include: A prohibition on lending to a single entity, so lending must be conducted through a program with broad-based eligibility. Program participants must demonstrate they can’t secure adequate credit from other sources. Participants may not be insolvent. The program or facility may not be structured “to remove assets from the balance sheet of a single and specific company, or . . . for the purpose of assisting a single and specific company avoid bankruptcy.” A stronger oversight role for Congress via detailed and timely reporting requirements. Prior approval of the Treasury Secretary for establishing an emergency lending facility. With the Dodd–Frank Act of 2010, Congress added these conditions to the Federal Reserve Act as a way of keeping the Fed from acting unilaterally in future crises. For example, these conditions would preclude an AIG-style bailout. In addition, the Treasury Secretary approval requirement would help ensure that elected officials, working with a congressionally confirmed cabinet member, could influence and oversee the creation and design of any emergency lending facilities. The 2020 pandemic suggests the Dodd–Frank Act may have strengthened the Fed’s policy response. Treasury Secretary Steven Mnuchin’s formal approval

When someone hears I’m currently writing the authorized biography of William (Bill) Sharpe, the most frequent question I get is, “Is he still alive?” Sharpe is the 1990 recipient of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, commonly known as the Nobel Prize in Economics. And, yes, in September 2024, he is still alive and well. He lives in Carmel-by-the-Sea in California. Every Thursday morning, he meets with his coffee klatch. He can often be seen walking his bichon-poodle near Carmel Bay. In June 2024, he celebrated his 90th birthday. And September 2024 was another Sharpe milestone: the 60th anniversary of his seminal capital asset pricing model (CAPM) paper in The Journal of Finance. It is extremely rare for research to remain relevant after a decade let alone six. I’ll explain what the paper is about, how it impacted the investment industry, most likely including your own portfolio, and why it still matters. Photo by Stephen R. Foerster The C-A-P-M Let’s talk about the model’s name, common acronym, and what it’s really about. First, Sharpe never called it the “capital asset pricing model.” As the title of his seminal article indicates, it’s about “capital asset prices.” Later researchers referred to it as a model, adding the M. Second, once it became known as the capital asset pricing model, it was referred to by the acronym CAPM, pronounced “cap-em.” Virtually every finance professor and student refer to it as “cap-em” — everyone except Sharpe himself. He always uses the initialism C-A-P-M. (So, if you want to honor the creator of the model, you can refer to it as the C-A-P-M!) Third, the focus isn’t really about prices of assets, but rather their expected returns. One of the key insights of the CAPM is that it answers an important investment question: “What is the expected return if I purchase security XYZ?” Key Assumptions Sharpe had written a paper published in 1963, “A Simplified Model for Portfolio Analysis,” that presented some of the same key concepts as in the seminal 1964 paper. There is an important difference between the two papers. As Sharpe later described it, in the 1963 paper, he carefully “put the rabbit in the hat” before pulling it out. The 1963 paper also answered that key question, “What is the expected return if I purchase security XYZ?” But the rabbit he put in the hat was a preordained relationship between a security and the overall market — what I’ll describe later as beta. Andrew Lo and I interviewed Sharpe for our book, In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest. “So, I spent several months trying to figure out how to do it without putting the rabbit in the hat,” he said. “Was there a way to pull the rabbit out of the hat without putting it in to begin with? I figured out yes, there was.” In the 1964 article, Sharpe didn’t put a rabbit in the hat but rather he derived a market equilibrium based on theory. With any theory, you need to make assumptions, to simplify what happens in the real world, so that you can get traction with the theoretical model. That’s what Sharpe did. He assumed that all that investors care about are expected returns and risk. He assumed investors were rational and well-diversified. And he assumed investors could borrow and lend and the same rate. When Sharpe initially submitted the paper for publication in The Journal of Finance, it was rejected, mainly because of Sharpe’s assumptions. The anonymous referee concluded that the assumptions Sharpe had made were so “preposterous” that all subsequent conclusions were “uninteresting.” Undeterred, two years later Sharpe made some paper tweaks, found a new editor, and the paper was published. The rest, as they say, is history. The CAPM in Pictures Much of Sharpe’s classic paper focuses on nine figures or graphs. The first seven are in two-dimensional space, with risk — as measured by the standard deviation of expected returns — on the vertical axis and expected return on the horizontal axis. (Any finance student will quickly note that the now-common practice is to flip axes, which is represent risk on the horizontal axis and expected return on the vertical axis.) On his horizontal axis, Sharpe began with the return on a special security that he called the “pure interest rate” or P. Today, we would refer to that special rate as the Treasury Bill return, or the risk-free rate, commonly represented as Rf. The curve igg’ is Harry Markowitz’s efficient frontier: the “optimal” combination of risky securities such that each portfolio on the curve has the highest expected return for a given level of risk, and also the lowest risk for a given level of expected return. Sharpe’s model essentially looked for combinations of the risk-free security, P, with each portfolio on the curve igg’ that would provide the optimal risk-expected return. It is clear from the graph that the optimal mix is formed by a line from P that is tangent to curve igg’ — in other words, the mix that combines the risk-free asset P and portfolio g. In Sharpe’s world, we can think of the investor as essentially having three choices. She can invest all of her money in risky portfolio g. If that’s too much risk for her, she can divide her portfolio between combinations of risk-free P and risky g. Or, if she wants even more risk she can borrow at the risk-free rate and invest more than 100% of her wealth in risky g, essentially moving along the line toward Z. The line PgZ is Sharpe’s famous Capital Market Line, showing the optimal combination of risk-free and risky investments, including either lending (buying a Treasury Bill) or borrowing (at the Treasury Bill rate). The Footnote that Won a Nobel Prize After presenting a series of graphs, Sharpe showed how this could lead to “a relatively

The cannabis sector is slowly emerging from its long period of prohibition, and the investment opportunities are turning heads. Retail investors believe in the industry’s future and want to participate before regulations change. The institutions covering the sector are keeping a close eye on it even if most have yet to dip their toes in. The cannabis industry constitutes a new frontier in investing and is ripe with growth opportunities. The hype and speculative froth of 2018 and early 2021 has burned off, and the market is right sizing: Valuations are more reflective of actual profitability, as cannabis companies suffer from the same dearth of capital as other areas of the private markets even as more US states legalize cannabis use. So, How Did We Get Here?  This is not the first time US consumers have had access to legal weed. In the colonial era, governments encouraged cannabis cultivation. The Virginia Assembly required farmers to grow hemp, a non-psychoactive cannabis variety used in the production of sails, ropes, and other textiles, and George Washington and Thomas Jefferson, among others, produced the crop. By the late 19th century, consumers could buy psychoactive cannabis at their local pharmacy.  The US government made its first foray into this otherwise free market in 1906 when it required that cannabis-infused products be labeled as such. But the real change in the perception and regulation of cannabis came with the Marihuana Tax Act of 1937, which ushered in the Reefer Madness era. Spearheaded by Harry Anslinger, commissioner of the Federal Bureau of Narcotics (FBN), a precursor to the Drug Enforcement Agency (DEA), the law sought to criminalize the sale and possession of cannabis. As the years progressed, cannabis became associated with the countercultural movements and anti-war protests of the 1950s, 1960s, and 1970s, and new laws imposed ever more severe penalties. But in the last few decades, amid a slow change in sentiment, the pendulum has begun to swing back, and prohibition has given way to pre-Anslinger acquiescence if not acceptance. California became the first state to legalize medical cannabis in 1996, and Colorado and Washington became the first to legalize recreational use in 2012. Today, recreational cannabis is legal in 23 states and its medical use in many more. Still, psychoactive cannabis remains illegal at the federal level. Today’s Fragmented Landscape  But as more states legalize cannabis, more Americans favor federal legalization. Young people are drinking less alcohol and consuming more marijuana. The stigma associated with cannabis use has dissipated. Among older cohorts, the market for cannabis wellness products shows great growth potential. The federal government last year removed a big hurdle in this regard. It withdrew the prohibition of federal funding for medical cannabis research and allowed doctors to discuss cannabis with their patients. Still, as a drug, cannabis retains the highest risk classification, along with heroin, LSD, and ecstasy, and is considered to have no proven medical benefit. According to these ratings, cocaine, methamphetamine, and fentanyl have a lower risk of abuse than cannabis. With more research into its medical benefits and lower potential for abuse, the pressure to reclassify cannabis will increase. Cannabis investing encompasses not only plant-touching companies — the growers, edible and joint manufacturers, and dispensaries — but also companies that provide services to cannabis firms, from technology to fertilizers. Plant-touching companies incur the federal government’s punitive cannabis tax structure. Because cannabis is still classified as an illicit substance, cannabis companies can deduct expenses only for cost of goods sold (COGS). This leaves a high effective tax rate that hits dispensaries, with their large staffing costs, especially hard.  That is why the prospect of federal legalization and relief from such tax treatment so excites investors. But their optimism is likely misplaced: They shouldn’t hold their breath. Much of the investment capital in the cannabis space continues to flow to non-plant-touching companies. This sell-shovels-to-gold-miners approach has obvious appeal. Businesses can avoid punitive taxation and potentially achieve greater profitability with less legal risk. Where Is the Money? Since it is illegal at the federal level, cannabis cannot be transported across state lines, nor can any capital associated with it be transmitted through the federal financial wire system. What this means in practice is that each state has its own microcosm of brands, products, plant types, and financial arrangements. The landscape for cannabis investors in Arkansas looks much different from what it does in California. This ecosystem of small players in small markets exists parallel to that of so-called multi-state operators. Such organizations set up individual companies in different states under the same name and can thus claim a cohesive multi-state operation, even if they can only sell their wares in the state where they were grown and manufactured. Multi-state operators have attracted most of the related investment capital. Their valuations shot to the moon amid the social isolation associated with the COVID-19 pandemic, the concomitant increase in recreational drug use, and expectations of potential federal legalization under a new Democratic administration. Needless to say, the hype going into 2021 was just that — a Green Rush — and cannabis valuations soon fell back to earth. Historical prices of MSOS, the first US focused cannabis exchange-traded fund (ETF), reflect this trajectory. AdvisorShares US Pure Cannabis ETF (MSOS) Performance2 September 2020 to 18 October 2023 Source: Bloomberg  Multi-state operators are now focused on consolidation and cost cutting. Smaller operators are either finding their competitive niches or shutting down. And a host of burned investors are vowing never to put money into cannabis. In other words, there is lots of blood on the cannabis sector’s streets. Many cannabis-focused investment shops opened during the bubble, when investors were throwing money at anything that smelled like marijuana. Several have lost more than 60% of their initial value and have conjured cannabis-market benchmarks to rationalize this massive wealth destruction.  While raising money for cannabis investments is much harder today, investors are still interested in the opportunities this nascent industry offers. Without reliable benchmarks or historical averages on

Faced with rampant inflation, central banks worldwide are raising interest rates. In June, the US Federal Reserve announced its largest hike since 1994. The previous month, the Bank of England (BOE) had pushed UK rates to a 13-year high. The central banks of Brazil, Canada, and Australia have also hiked, and the European Central Bank (ECB) plans to follow suit later this month. Such rate increases not only create turmoil in risk markets; they also can threaten a company’s financial stability. The devil is in the details when quantifying how these hikes will influence a firm’s bottom line. Beyond the obvious implications on financing costs, capturing the impact on economic value requires a more strategic and holistic approach. As we demonstrate here, the effect differs according to how heavy and active the company’s assets and liabilities are. The calculation becomes even more complex for finance or investment firms that juggle multiple balance sheets at once. Yet financial risk management and market risk hedging are critical to every firm’s prosperity, so analysts need to understand the available tools. Economic Value of Equity (EVE) Economic value of equity (EVE), or net worth, defines the difference between assets and liabilities according to their respective market values. EVE represents the income or loss a firm faces during the chosen horizon or time bucket. Hence, EVE reflects how assets and liabilities would react to changes in interest rates. EVE is a popular metric used in the interest rate risk in banking book (IRRBB) calculations, and banks commonly measure IRRBB with it. But EVE can also help companies — and the analysts who cover them — calculate the risk to their dynamic assets and liabilities. The metric looks at the cash flow calculation that results from netting the present value of the expected cash flows on liabilities, or the market value of liabilities (MVL), from the present value of all expected asset cash flows, or the market value of assets (MVA). While EVE, as a static number, is crucial, what also matters to a company’s health is how EVE would change for every unit of interest rate movement. So, to calculate the change in EVE, we take the delta (Δ) of market values for both assets and liabilities. That is, ΔEVE = ΔMVA – ΔMVL. The beauty of this measure is that it quantifies the ΔEVE for any chosen time bucket and allows us to create as many different buckets as we require. The following table tracks the changes of a hypothetical company’s EVE assuming a 1 basis point parallel increase in interest rates. Bucket ΔMVA ΔMVL ΔEVE 1-month -$13,889 $35,195 $21,306 2-month -$27,376 $9,757 -$17,620 3-month -$39,017 $16,811 -$22,205 6-month -$180,995 $72,449 -$108,546 1-year -$551,149 $750,815 $199,667 3-year -$3,119,273 $1,428,251 -$1,691,023 5-year -$1,529,402 $115,490 -$1,413,912 More than 5-year -$264 $403 $139  Net Change -$5,461,364 $2,429,170 -$3,032,194 What Is an Acceptable EVE? Economic intuition tells us that long-term assets and liabilities are more vulnerable to interest rate changes because of their stickiness, so they are not subject to re-fixing in the short term. In the chart above, the net change in EVE is -$3,032,194 for every basis point increase across the interest rate curve, and we have the necessary granularity to determine the buckets where the company is most vulnerable. How can a firm bridge this gap? What is the optimal allocation between the duration/amounts of assets and liabilities? First, every institution has its own optimal allocation. One size does not fit all. Each firm’s risk profile and pre-set risk appetite will drive the optimal EVE. Asset and liability management (ALM) is doubtless an art: it helps translate the company’s risk profile into reality. Since EVE is primarily a long-term metric, it can be volatile when the interest rate changes. This necessitates applying market best practices when following a stressing technique, such as value at risk (VaR), that helps to understand and anticipate future interest rate movements. On and Off the Balance Sheet A company can manage the EVE gap between assets and liabilities — and the related risk-mitigation practices — either on the balance sheet or off it. An example of on-balance-sheet hedging is when a firm simply obtains fixed interest rate financing, rather than linking it to a floating index, such as US LIBOR, or issuing a fixed bond to normalize the duration gap between assets and liabilities. Off-balance-sheet hedging maintains the mismatch in the assets and liabilities but uses financial derivatives to create the desired outcome synthetically. In this approach, many firms use vanilla interest rate swaps (IRS) or interest rate cap derivative instruments. Details of the balance sheet gap are not always available for examination when reviewing the financial statements. However, decision makers and investors must pay attention to it and be vigilant because the EVE metric captures the market value of the cumulative cash flows over the coming years. And as we’ve shown above, calculating it is simple. A Safety Valve for an Uncertain Future With a little due diligence, we can better understand how a company manages its interest rate exposure and associated ALM processes. Although banks and large financial institutions make ample use of the EVE indicator, other companies ought to as well. And so should analysts. When a firm sets limits for risks, monitors them, and understands the accompanying changes in value due to interest rate movements and how they will impact its financial position, it creates a safety valve that protects against market risks and an uncertain interest rate outlook. If you liked this post, don’t forget to subscribe to the Enterprising Investor. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images/Heiko Küverling Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

A version of this article originally appeared on the Research Affiliates website. The current economic environment is a confusing one. Job growth is strong, yet reports of layoffs at high-profile companies are ubiquitous. The yield curve is inverted, implying an imminent recession, but the stock market is at or near record highs. What can we make of these contradictory signals? Can the economy achieve the hoped-for soft landing of slower economic growth or a mild recession? Or is a hard landing and a regular or even severe recession inevitable? Provided the US Federal Reserve awakens from its slumber and certain other mitigating factors persist, I believe we can still stick the landing. But many pieces have to fall into place. The inverted yield curve casts a long shadow. I unveiled this economic growth and recession indicator in my dissertation many years ago. Since the 1960s, it has anticipated eight out of eight recessions and has yet to send a false signal. Measured as the difference between the yields of the 10-year Treasury bond yield and the three-month Treasury bill, the yield curve inverted in November 2022, leading many to expect a recession in 2023. When none materialized, some concluded that the yield curve had sent a false signal. That judgment was premature. Over the last four cycles, an inverted yield curve has given, on average, 13 months’ advance warning of a recession. The yield curve inverted only 16 months ago, which is not that far off the mean. Furthermore, over the last four cycles, short rates have fallen back to their “normal” position below long rates — that is, the yield curve “uninverts” — before the recession begins. That uninversion has yet to occur. Given the yield curve’s track record, we ignore it at great peril. It now indicates growth will substantially slow in 2024 and may or may not lead to recession. Even in a soft-landing scenario, a minor recession is possible. That has happened twice before, in 2001 and from 1990 to 1991, with GDP drawdowns around 1%, as shown in the following chart. The key is to avoid a deep recession like the one associated with the global financial crisis (GFC). Total GDP Decline in Recession, Peak to Trough The US economy delivered 2.5% real GDP growth in 2023 and expanded at a 3.3% rate in the fourth quarter. I expect much slower growth in the first and second quarters in 2024 because of four headwinds in particular: Four Headwinds 1. Consumer Behavior Personal consumption expenditure is the most critical component of GDP, representing 68% of overall growth. Consumer spending drove much of the 2.5% year-over-year (YoY) expansion in real GDP in 2023. Combined personal consumption and government spending accounted for 87% of that growth. What explains this strength? During the pandemic, consumers amassed $2.1 trillion in excess savings, according to the Fed, so there was considerable pent-up demand as well as generous government support programs. Consumers have been drawing these savings down, which fueled their 2023 spending binge. Investment is another key aspect of GDP, and it did not benefit from such government support. In fact, with negative YoY investment in 2023, it may already be in a recessionary state. The leading indicators of consumer savings are important to watch. When savings run out, spending contracts. Consumer loan delinquencies, for example on autos and credit cards, is an intuitive metric. Consumers will only borrow on credit cards with rates in the 20% range when their savings have run dry. Delinquencies have been trending upward, signaling that consumers have depleted much of their savings. Other technical factors also come into play. In October 2023, the pandemic-era pause in student loan repayments ended, and roughly 40 million Americans had to begin repaying this debt directly out of their disposable income. 2. Credit Conditions The largest banks offer only a few basis points in annual interest on savings deposits. The average savings rate is about 0.5% and skewed by somewhat higher rates at small and regional banks. It may not receive much attention, but this indicates bank weakness and is bad news for the economy. Consumers can move their savings into money market mutual funds (MMMFs) and easily receive a 5% rate of return. Capital is flying from savings accounts to ultra-safe MMMFs. This has two implications: As assets move to MMMFs, banks have less to lend. While the effect is not immediate, credit conditions should tighten this year. That means lower spending by consumers and businesses and, as the cost of capital rises, reduced business investment. Many consumers will not transfer their assets to MMMFs. Some don’t know that their savings account interest rate is so low, and others have small balances that might not qualify for MMMFs or enhanced savings rates. These consumers suffer as the value of their modest assets erodes because their savings rates are so much lower than the current rate of inflation. Yield Disequilibrium 3. Commercial Real Estate (CRE) COVID-19 structurally changed the nature of work in the United States. We now live in the era of remote and hybrid work, of work from home (WFH). Public transportation use plummeted during the pandemic and then recovered somewhat but has yet to return to pre-COVID-19 levels. Indeed, the data are flattening out well beneath where they were in early 2020, which is consistent with a structural change. New York Metropolitan Transportation Authority (MTA): Daily Ridership Decline Relative to Pre-Pandemic Equivalent Day San Francisco, among other cities, has enormous office vacancy rates. The commercial real estate (CRE) market will be a big story in 2024. While the sector had problems in 2023, the media didn’t pay much attention — probably because the loans were not coming due — but they will soon. Refinancing will be necessary this year. This poses a risk to banks, CRE’s principal financiers. The recent plunge in the value of New York Community Bancorp is just one indication of the stress regional banks are under. 4. Interest Service Obligations on

Saudi Arabia’s economy is surging. The debt market tells the story: Banks in the Kingdom have extended more than SAR 2.2 trillion — that’s $587 billion in US dollars — in credit facilities to the private sector, with half of those credit facilities long-term, as of December 2022. These are record numbers and reveal the momentum behind Saud Arabia’s exceptional growth story. Public-private partnership (PPP) transactions and the wider project finance industry are core to that momentum. Indeed, such projects are expanding at an accelerated pace, supported by infrastructure projects prioritized by the government as well as mega and giga projects across the country. Yet this remarkable growth comes with risks — interest rate risk, in particular. The three-month Saudi Arabian Interbank Offer Rate (SAIBOR) over the last 10 years shows a recent surge and rising volatility. Compared with just 0.52% for the first five years, the daily standard deviation has more than doubled to 1.21% over the last five. Three-Month SAIBOR Historical Curve This raises questions about how interest rate risk should be allocated between the two primary stakeholders in any project finance transaction: the project company and the beneficiary entity. The former is a special purpose entity created to deliver the project and whose only asset is the project, while the latter, also called the off-taker or the procurer, pays the project company to deliver the agreed scope. So, how can these two stakeholders best split the interest rate risk? The Local Market Brief The allocation of interest rate risk differs by project, but the conventional approach in Saudi Arabia puts the onus on off-takers. These beneficiary entities assume the interest rate risk as outlined in the winning bidder’s initial financial model through the hedge execution date. The bidder’s profitability is shielded from any interest rate volatility until the hedge execution. If the interest rate rises above the assumed rate at the execution date, the financial model is adjusted to maintain the profitability metrics, with the off-taker paying for the interest rate deviation. If the interest rate falls, however, the benefits go to the off-taker. To balance this equation, the stakeholders need to agree on an optimal hedging strategy and understand from the outset how the interest rate risk is allocated. Here’s what needs to be done at the four key stages of the project finance process to achieve these outcomes. 1. The Pre-Bid Stage The project company must devise and articulate a hedging strategy that specifies the hedge duration, optimal hedging quantum, and the instrument under consideration, among other critical factors. A smooth close-out requires buy-in from the lenders and hedge providers. The project company’s goal is a successful close. As such, it should focus on securing the financing and executing the relevant documents as soon as possible. If the hedging element isn’t well planned, it could create delays and saddle the project company with unfavorable economic terms. To establish the financial model and forecast, the project company must calculate the interest rate risk allocation before submitting its bid. For instance, if the planned financing is long term and the financing currency is not liquid enough for the whole hedge tenor, the project company should quantify the impact and build it into the project economics. Will the off-taker continue to compensate the project company for the interest rate risk of the unhedged portion after hedge execution? That must be clear early on. Will the off-taker participate in the subsequent gains but not the losses? If so, the project company needs to make an assessment. Any margin the hedge providers make is usually excluded from the off-taker compensation plan since the project company bears the cost. That’s why the project company needs to plan and discuss the hedging credit spread with the hedge providers. 2. The Post-Bid Pre-Financial Close Stage This is the key juncture in project finance, and its success or failure hinges on the project company’s grasp of the pre-bid stage agreement. The project company might prefer that all parties agree on a hedge credit spread or that the spread be uniform across the lenders or hedge providers. But sometimes a credit spread based on the risks carried by the lenders may make sense. At other times, the project company may favor credit spread competition among the hedge providers. In that case, every lender has a right to match according to the debt size on a prorated basis. The downside of this approach is that it might cost the lender an opportunity to participate in an income-generating trade, which could make the transactions less profitable than forecast.  If there is a minimum mandatory hedging requirement for long-term financing, the project company could obtain a tighter credit spread for the subsequent tranches. However, lower risk during the project completion or operation periods could mean this spread is better than the first tranche. Without an open dialogue at the outset, the project company accepts — by default — the initial credit spread for the subsequent hedges. A hedging protocol should be drafted early and align with the agreed hedging strategy. The party that assumes the interest rate risk typically has more flexibility to design the protocol to ensure fairness, prudence, and transparency. A dry run (rehearsal) of the hedge helps test the protocol’s reliability. But that requires an independent bench marker to validate the lowest competitive rate. The lowest rate is not always the best. Project finance transactions involve complex financial modeling, and the cash flows change based on the hedge rate. Therefore, coordinating timely turnarounds with the updated cash flow is crucial. The financial/hedge adviser must administer the process according to how the hedging protocol defines it. Some project companies and off-takers may put an acceptable deviation limit between the assumed floating curve and the actual market rates, but each party must understand what’s at stake and set appropriate thresholds. The International Swaps and Derivatives Association (ISDA) Agreement and schedule specify the terms of the derivative dealings. The schedule is customized and negotiated on both commercial and legal

The financial markets are among the most effective tools we have to fight climate change, and the net zero transition will require trillions of dollars in annual investment between now and 2050, according to analysts. While that’s certainly an impressive number, given specific climate exposure-related mandates, investors at this stage want to understand the risk and return dynamics reflected in a company’s environmental score. So, how can investors assess climate transition risk in their portfolios? Both to answer this question and to better understand the relationship between stock returns and a company’s carbon emissions., I conducted a comprehensive analysis of MSCI Europe returns from 2007 to 2022 that incorporates supply-chain related Scope 3 emissions. The study revealed two intriguing findings. 1. Time Frames Matter Simply adding one or two years to a sample period can dramatically change the results. Many previous climate finance studies only covered bullish market cycles. Sustainable investments in Europe performed well between 2010 and 2021, for example. But if we extend the time frame to year-end 2022, thus incorporating the energy crisis that followed Russia’s invasion of Ukraine, that “green” alpha evaporates. Even before the pandemic, amid disappointing energy sector returns, investors had redirected their capital from old economy stocks to their new economy counterparts. Then, several years of insufficient CapEx investment contributed to an energy supply deficit that only manifested itself as the global economy transitioned into the post-pandemic recovery phase. The war in Ukraine further exacerbated this effect, causing a huge spike in energy prices. Following the global financial crisis (GFC), monetary policy dominated the financial landscape. Low and negative interest rates and quantitative easing (QE) helped create bubbles in certain assets. The lower-for-longer interest rate environment pushed growth stocks — with their longer-term cash flow horizons relative to value stocks — to overshoot. Glamour stocks — think Tesla — soared as old economy stalwarts, with their tendency to generate higher emissions, sputtered. To put this in perspective, long-term cash flows are now discounted at over 5%. Before 2020, the norm was below 1%. One possible explanation for this is that other variables correlate with the GreenMinusBrown (GMB) factor. According to my analysis, the High Minus Low (HML) factor has a moderately negative correlation to the GMB factor. Since the HML factor’s style is more value than growth, the GMB factor may have more of a correlation with growth stocks. This makes intuitive sense: After all, green portfolios tend to be a combination of technology and health care stocks. Such stocks will often outperform when interest rates are low, as they were from 2010 to 2021, for example, when growth outpaced value. 2. Emissions = Perceived Risks There is also evidence of a positive relationship between a company’s greenhouse emissions and the perceived risk associated with that company. Brown portfolios are always more volatile than their green peers, and their level of absolute risk grows when Scope 3 emissions are included. Indeed, the Scope 1, 2, 3 Intensity emissions ranked portfolios demonstrate the largest volatility spread. This means that the higher returns that brown companies generate reflect their higher risk. In Europe, green portfolios have been slightly less volatile on average than brown over the past 15 years. This is in line with CAPM predictions and with research exploring how green investments can help hedge client portfolios. In theory, if green assets provide a hedge against climate risk, among other benefits, and are perceived as less risky because of their climate-resilient nature and other positive social impacts, investors may be willing to accept lower expected returns to hold them.  Returns on Green and Brown Portfolios on Scope 1, 2, 3 Intensity This figure plots the green and brown portfolios’ cumulative returns for the MSCI Europe from 2007 to 2022. The Scope 3 Emissions Effect is essential to understanding green exposure. The regression analysis exhibits the greatest explanatory power when it incorporates Scope 3 emissions. As such, the model better captures the full extent of a company’s sustainability performance. Scope 3 emissions will only become more relevant: New regulatory developments and reporting standards in Europe require companies to disclose these emissions beginning in 2024. The risk management theme is at the core of climate finance and anticipates a positive correlation between greenhouse gas emissions and stock returns, or a negative correlation between emissions and company valuations. Investors recognize that firms with strong environmental practices are more likely to be sustainable in the long term and are better positioned to navigate changing regulations, consumer preferences, and market dynamics, and are thus attractive investments.  So, What’s the Takeaway? The distinction between brown and green performance may not be so clear cut. Why? Because interest rates, investment trends, and other phenomena can influence sector performance. Moreover, many factor models assume that governments around the world will implement policy changes in the future. Carbon taxes, among other measures, have been discussed as potential tools for solving climate issues, and many models anticipate they will be implemented sometime in the months and years ahead. But the impact of such changes in climate change policy have yet to take effect or appear in financial returns. These conclusions aside, reducing climate risk exposure has several implications for investors. First, conservative investors will try to reduce their transition risk by hedging their exposure to it, and investors with exposure to transition risk will expect higher returns as compensation. If they don’t think they are earning enough return on that risk, they will engage with their companies and try to persuade them to hedge that risk. For corporates, on the other hand, transition risk management has one principal consequence: The more exposure to climate change risk, the higher the cost of capital. That implies both lower price multiples on future earnings and higher break-even rates on new investments. If you liked this post, don’t forget to subscribe to Enterprising Investor and the CFA Institute Research and Policy Center. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily

Under the private equity fundraising model, every few years fund managers secure capital commitments with a 10-year duration and charge management and advisory fees during the lock-up period. While longer-dated products have emerged over time, the basic pattern has remained essentially unchanged. Unfortunately, fundraising is cyclical. Downturns require patience: Fund managers must wait until the green shoots of recovery appear before going back to market for a new vintage. Clearing the Fundraising Hurdle Economic slowdowns affect the credit supply, capital availability, and the health of portfolio assets. In the wake of the global financial crisis (GFC), even large firms like UK-based Terra Firma couldn’t close a fresh vintage, while others — BC Partners, for example — barely survived, maintaining their asset bases but never truly expanding again. Global operators, too, struggled to get back on the growth path. Some, such as TPG and Providence Equity, had difficulty attracting fresh commitments and raised far less than they had for their pre-GFC vehicles. KKR took eight years to close a new flagship buyout fund, collecting $9 billion in 2014, barely half the $17.6 billion it had generated for its previous vintage. While small fund managers were stuck with the legacy model, the largest players looked elsewhere for solutions. Vertical integration was one path forward: For example, Carlyle acquired fund of funds manager Alpinvest from pension funds APG and PGGM in 2011. Warren Buffett’s Berkshire Hathaway offered PE firms a new template. Thanks to the float of its car insurance unit, GEICO, the company has permanent access to a perennial pool of capital. Apollo, Blackstone, and KKR, among others, all acquired insurance businesses over the past decade to harvest a similar fount of capital and leverage a perpetual source of fees. Indecent Exposure But there is a snag. Insurance is sensitive to random variables: Rampant inflation, for example, leads to higher claims costs and lower profits, especially for property-liability insurers. Sudden interest rate movements or, in the case of life insurers, unexpectedly high mortality rates (e.g., due to a pandemic) can have outsized effects on the bottom line. The Financial Stability Board (FSB) in the United States suspended the global systemically important insurer (GSII) designation two years ago, acknowledging that the insurance industry, unlike its banking counterpart, does not present a systemic risk. But the macroeconomic backdrop is much harder to control than corporate matters and can hinder cash flows. As such, the failure of an individual insurer might not have a domino effect, but it could be precipitated by a severe lack of liquidity. That outcome is more likely when the insurer is exposed to illiquid private markets. So, a sustained economic crisis could impede a PE-owned insurer’s ability to underwrite policies, issue annuities, or settle claims. Insurers have a public mission to cover the health or property of their various policyholders. PE firms, on the other hand, have a primary fiduciary duty to institutional investors. Indeed, unlike private capital, the insurance industry is highly regulated with strict legal obligations. This has critical implications. For example, past customer service and corporate governance issues at life insurers Athene and Global Atlantic, today owned respectively by Apollo and KKR, resulted in heavy fines. Such incidents can expose private capital to public scrutiny and make the trade more unpredictable, especially when insurance activities account for much of the business. Last year, for instance, Athene represented 30% of Apollo’s revenue. Alternatives Supermarkets Another solution to the PE fundraising dilemma was asset diversification, a blueprint first implemented by commercial banks in the late 1990s and early 2000s. Citi and the Royal Bank of Scotland (RBS) acquired or established capital market units and insurance activities to give clients a one-stop shop. Cross-selling has the dual advantage of making each account more profitable and increasing customer stickiness. Blackstone, Apollo, Carlyle, and KKR (BACK) built similar platforms to help yield-seeking LP investors diversify across the alternative asset class. They now offer single-digit-yielding products like credit alongside riskier higher-return leverage buyout solutions as well as longer-dated but low-yielding infrastructure and real asset investments. By raising funds for separate and independent asset classes, BACK firms shield themselves from a potential capital market shutdown. While debt markets suffered during the GFC, for example, infrastructure showed remarkable resilience. Still, such innovations have drawbacks. “Universal” banks underperformed their smaller and more tightly managed rivals. Opportunistic deal-doing betrayed a lack of focus. For instance, RBS acquired used-car dealership Dixon Motors in 2002 despite little evidence of potential synergies. In addition, a pathological obsession with return on equity (ROE) failed to account for the declining quality of the underlying assets. Moreover, retail bankers frequently proved to be mediocre traders, M&A brokers, corporate lenders, and insurers. Early indications suggest that multi-product platforms like BACK may not be able to produce the best results across the full spectrum of private markets. Carlyle’s mortgage-bond fund operations and its activities in Central Europe, Eastern Europe, and Africa as well as KKR’s European buyout unit all failed or struggled in the past, which demonstrates the challenge of monitoring and maintaining performance across the board while running a financial conglomerate. Murky product-bundling may further hamper returns at these world-straddling alternative asset supermarkets. A Performance Conundrum That diversification decreases risk while lowering expected returns is one of economic theory’s bedrock principles. Yet, in 2008, diversification at “universal” banks showed how risk can be mispriced when the performance correlation between products is underestimated. Risk can increase when all-out growth strategies are not accompanied by adequate checks and balances. The quasi-exclusive emphasis on capital accumulation and fee-related earnings by publicly listed alternative fund managers may come at the expense of future returns. This is one lesson of Berkshire Hathaway’s business model that the new breed of PE firms may not recognize. Achieving unconditional access to a capital pool is one thing; putting that capital to work is quite another. The cash surplus from the insurance float — over $100 billion as of 30 June –has made it virtually impossible for Berkshire Hathaway to beat public