JAMIE MCDONALD: In this episode of our series on the Building Blocks of Finance, we will take a closer look at the most well-known of our four key asset classes equities. Now, when people think of the world of finance, the first thing that usually comes into people's head is the stock market. In some ways, it's the lead singer of financial assets. It's volatile, it's exciting, and more often than not, it's the one that gets written about the most.

And for good reason, at least in the US outside of their primary residence, many people have a majority of their personal investments and retirement savings tied up in the stock market. But as we mentioned in our intro episode, there are three other members of the band, fixed income, commodities, and currencies, and they have their crucial interconnecting roles too. But before we get too far into the nitty gritty, let's start with the most basic question. What is an equity?

In its most basic form, equity is an ownership claim in a business or property that gives the holder the right to a value of the assets left over after all the debt has been paid off, should that business or property be liquidated. So, equity sits behind debt in the capital structure. This means when a liquidation of assets occurs, debt or the fixed income part of the capital structure gets paid back first. For a physical property like a home, it's very easy to conceive of is there is usually just one debt claim, the mortgage.

And depending on how much of that mortgage has been paid off, some level of equity is left for the homeowner. Whatever the house can be sold for above the remaining amount left on the mortgage is equity. For businesses though, this begins to get more complicated. You have uncertain future cash flows, the value of the brand and other intangibles like intellectual property and human capital. And so, these valuations become harder to calculate.

But it's exactly this uncertainty that creates the very volatility and potential for capital appreciation that attracts so many to equity markets. This equity also normally comes with voting rights to determine how the businesses run and who its leaders will be. But this is much more typical in private markets than in public markets where uniform common shares are nearly ubiquitous these days. So, now that we have a basic understanding of what equity is, let's take a look at how equity could be broken down into subgroups and how those groups interact with each other, and the three other asset classes.

Almost by definition, every company starts out as a private company. If the business is still maturing, this is known as venture capital. But venture is just a subset of private equity. In general, though, when people refer to private equity, they're referring to companies that are past this initial growth stage and are not publicly traded. Within private equity, you have businesses that range from small Mom and Pop shops to massive multinational corporations that could probably be publicly traded if the owners so desired.

Private equity markets are affected by public equity markets as going public is their chance to cash out. If public equity markets are weak, there's a strong chance that private markets will be feeling the same weakness. But also note, fixed income is deeply connected in private equity. Businesses still need to tap debt markets for funding. They have valuations measured by discounted cash flows where interest rates are a major factor. Plus, the relative attractiveness of other fixed income alternatives can push allocators into or out of private equity, which is viewed however incorrectly as a diversified uncorrelated to public equity.

Naturally, commodity intensive private businesses and those conducting international trade have to worry about both commodity and currency markets in the same way as their public equity counterparts. Historically, private businesses were always the norm until the Dutch East India Company became the first company to issue shares of equity to the public and this makes sense. Before then, a company wouldn't go through the trouble of raising money from 1000s of different people if it could just go through one.

But by then, the Dutch East India Company had become too big and needed more money than could be raised through one individual investor or syndicate deal, hence, the public offering. The issue of size is key to the existence of public markets. Although there were public shares before the industrial age, the modern US stock market is really due to the massive wealth that was created during the 19th century. By the end of the 19th century, these large usually private family businesses with third generation operators needed a way to exit these investments as they no longer had the skills nor the desire to be stewards of capital, but neither did the rest of their peers.

So, a private buyout was out of the question. Those owners, therefore, when to list their shares on public exchanges, selling to the masses, and walking away with massive fortunes, which is why a company going public is often referred to by private investors as an exit. These public equities can be broken down by a number of different methods, which in general apply to private equity too, but a much more often referenced in relation to public markets.

After companies are listed, they usually trade on a local exchange, but if the company has enough desire for international investment, it can trade on multiple exchanges all over the world. Today, the world has around 60 major stock markets with 16 of them having over $1 trillion of market cap, but these aren't all made equal. The mighty NYSC has a market cap larger than the 50 smallest exchanges combined.

The largest and most developed markets like the US and Canada, Western Europe, Australia, New Zealand, Japan, are called developed markets, while the rest of the world's markets are referred to as emerging markets with the most underdeveloped, sometimes called frontier markets. What separates a DM from an EM, or an FM is both the stage of the economy and the maturity of capital markets in that country. These definitions are not perfect though.

Some countries like South Korea, for instance, are still considered emerging markets, even though its economy has a closer resemblance to developed markets than it does say, Indonesia. Emerging market equities often have a closer relationship to commodities, as these less developed economies rely more heavily on their natural resource base for economic output. Fixed Income funding is generally more expensive and sometimes these countries need to issue debt in foreign currencies bringing currency risk into the equation.

So, equities have geographic differences, and that geography can mean different valuations. One company that sells soap in the United States might have near identical financials to a company in Russia, but the equity could have a different value. It's important to pay attention to these valuation paradigms and their causes before you go buying foreign equities simply because they look cheap.

In addition to geographic differences in valuing equity, valuations differ across sectors and business type. The most commonly accepted and comprehensive breakdown is known as the GICS or Global Industry Classification Standard, which was developed by MSCI and Standard and Poor's. The system breaks down equities into 11 sectors, 24 industry groups, 69 Industries, and 158 different sub-industries. Depending on your level of specialization, you may do all of your investing in just one specific sector, where it's important for you to know all the way down to sub-industries.

But some large allocators just don't have the time and frankly, have too much money to allocate to concern themselves with that level of detail and the 11 sectors are enough stratification to make investment decisions. As we discussed in the business cycle tutorial, sectors split into defensive and cyclical and perform differently throughout the full business cycle. Cyclical sectors tend to be supported by growth in the economy, while defensives as the name suggests, performed more conservatively in both ups and downs. We'll take a closer look at these in future episodes.

Another way to stratify equities is by their market capitalization or size. The largest companies in the world referred to as large cap stocks are worth $10 billion or more. In the past few decades though, some companies have grown so large that they've received that own moniker of mega cap stocks. There's yet to be a specific definition with some saying more than a trillion dollars and others saying a measly 100 billion is enough to qualify.

But moving down the chain, we have mid cap stocks at $2 to $10 billion, small caps at $300 million to $2 billion, micro-cap stocks at $50 million to $300 million and nano cap stocks at less than $15 million. These size differences have a direct impact on the amount any investor can own, and still feel safe to sell if the facts change. This means that some of these companies further down the food chain may never be invested in by a large institution, as it isn't worth their time to devote resources to something in which they may only be able to buy a few million dollars' worth.

That is where retail investors can potentially look for some edge. If companies don't meet certain requirements, they may be delisted from exchanges and trade over the counter or OTC. This can happen because the company is too small, or it doesn't meet the financial requirements of that exchange. Often these are smaller companies but there are certainly exceptions. The Wolf of Wall Street's familiarized many people with the term pink sheet. This is just another name for over the counter stocks, which traded for less than $1 per share, hence being known as penny stocks.

One of the main reasons that equities and fixed income markets are so intertwined beyond just the intra company capital structure is that they often sit next to each other in people's portfolios. One of the most common portfolios in the world is the 60/40 Portfolio, with 60% in equities and 40% in fixed income. The lower volatility of fixed income is supposed to smooth out the more volatile equity returns whilst also providing a hedge. As for decades, bonds have shown an inverse correlation to stocks.

Now, these portfolios are usually rebalanced regularly, meaning that when one outperforms the other, the leader is sold, and the lagging asset class is bored. Other portfolios have similar constructions but use leverage to match the volatility. These are generally known as risk parity. If volatility stays normal, the same rebalancing dynamic takes place rather timely, but when volatility of one asset class spikes, the portfolio's need to be adjusted. This is known as VAR shock or Value at Risk shock, as VAR is the calculation used to construct these risk parity portfolios.

Because the standard procedure is to de-lever the asset class which has spiked rather than lever the other, selling and sometimes crashes are the end results of these VAR shocks. So, do be aware that risk parity can fail as a strategy, especially when correlation goes to one in the event of a massive sell off. In fact, let's address equities in a crisis on that note.

In a crisis, like the vast shock above, bonds and equities can be sold off together. And that's exactly what happened in 2020, and it led to liquidations of currencies and commodities, too. In fact, investors looked for liquidity anywhere they could get it. And as the saying goes, in a crisis, you sell what you can, not what you want. These knock on effects into other asset classes are common, but one thing that is near certainty, and that is when these crises occur, equity correlations move towards one.

Furthermore, the equity market is increasingly dominated by passive players who instead of investing in individual companies prefer to spread their bets across passive indices, like the S&P 500 and the MSCI emerging markets index. When equities come under intense pressure, these passive indices ensure that almost everything will move in unison. And because liquidity is in such short supply, these likely spills over into equities not included in indices leaving virtually no equity safe as a place to hide.

Now, that we've discussed how common portfolio constructions can lead to interactions between equity and fixed income, we need to take a closer look at how credit markets and equity markets interact. The big question is whether loose credit markets lead to equity bubbles or if they are coincident. The argument for the former is that easy credit allows companies to kick the can down the road and maintain equity value. The argument for the latter is that tight credit spreads in environments where even the most unsavory borrowers can tap credit markets lend themselves to high equity prices.

The ease of the credit market is the result of too much money chasing not enough assets. Naturally, one would expect that bubbles would occur at the same time as easy credit. In truth, they do often occur together, but it isn't always the case. In 2000, equities we're in a bubble but credit wasn't. In 2008, credit was the issue, but equities could hardly have been called the bubble. One similarity for both though, is that when the music finally stopped, neither market was spared from the turmoil. And what we're talking about collectively here is the idea of contagion, namely that a crisis in one market usually spills over into others.

To conclude, equity is almost certainly going to be a part of every investor's portfolio. But as you can see, what drives equity returns is so much more than how that individual business performs. Emerging market equities can be moved by the dollar, credit markets can play a huge role in kicking the can down the road keeping equities high, and even the Treasury markets can spill over into equity markets if volatility spikes.

Hopefully after this tutorial, you've come away with a better understanding of how connections exist between equities and the three other core building blocks. But there is still so much more to cover here to fully understand these dynamics. And in future episodes, we'll be diving deeper and exploring them from different perspectives. You'll notice that in this episode, we examine the interactions between equity markets and other asset classes with a specific focus on fixed income, but it was all from the perspective of equity.

It's equally important to get the alternative perspective. So, we highly encourage everyone to watch the other episodes like fixed income, commodity and currencies and other past Investor Tutorials. After all, we're building a Cross-Asset Framework, so let's not get distracted by the lead vocals of the stock market.