Looking for rewards in a maze

What indeed does the market reward? This is the question that vexes the idiot-savants, the scoundrels and the sages on Wall Street.

While our knowledge about the asset bubbles might not be markedly wiser than the days of the Tulip Mania in 1600s, there is consensus on the following. Any market price movement has two contributing factors - the predictable and the unpredictable component. Standard market efficiency theories posit that all information "out there" is captured in the price of the asset. Thanks to the market's ruthless efficiency. Any price movement, going forward, can be attributed to surprises. Be it better results in a quarter or sudden illness of the CEO. So, as long as you are able to estimate the unpredictable better, you come out ahead. The bigger the surprise, the bigger the rewards!

However, in contrast to equities, the debates on potential paths to recovery following this "great recession" can be categorized by veritable alphabet soup of monikers have been offered. For eg., in the US, the recessions have been pegged as follows: the W-shaped (the 1980-81s), the U-shaped (think 1970s US), the V-shaped (the1990-91/2001) and the most ominous L-shaped recession seen in Japan. These shapes refer to economic growth and their path over time. Unlike the theorizations for equities - there is no clear framework to think about the potential path of the macroeconomy. At best, we can rely on statistical inferences from trajectories of key variables like capacity utilization or monetary base etc., Since Thales of Miletus made a fortune, in 600BC, in futures contracts on olive presses after observing the weather - making money in the market is about the art of understanding correlations.

Correlations, however, are dangerous beasts. But unfortunately, at the risk of being eaten alive (ask Goldman Sach's Global Alpha!), studying and betting on correlations is the only game in town. Traders and risk managers are paranoid about unanticipated correlations lurking in their portfolio. Will the drought in India affect the price of Cadbury stocks - via the shortage of sugar? These are the kind of correlations that keep asset managers awake at night!

One useful, and highly reliable, survey that is impressively correlated to the US market is the ISM Manufacturing Report on Business. Since 1931, they have tracked and created indices for US manufacturing and more recently, non-manufacturing. Across the political landscape - from Alan Greenspan on the Right to Joseph Stiglitz on the Left - the ISM is highly respected for explaining the variation in US GDP. The most recent August survey results report three principal trends. While inventories and employment have been shrinking for 40 and 13 months respectively - "new orders" in manufacturing have grown dramatically for 2 months and the overall economy has been growing for 4 months in a row. There is substantive econometric evidence that employment figures are highly correlated with "new orders" in the survey results. These lead me to believe that economic recovery will accelerate faster than our generic gloom-and-doom scenarios have led us to intuit.

So, in order to reward oneself, the original question remains. What does the market reward? Historical data reveals, as employment figures improve, the payroll figures will improve and so will consumer spending. Less obvious is that as employment numbers pick up, the repayment levels of personal mortgages and the commercial real estate mortgages improves. One industry that will inescapably benefit from these movements is the banking sector. The price-to-book ratio of the S&P500 Banks Index, as per Barclays Global, is at 0.92 while the consumer discretionary sector's ratio is at 3.16. The scope for improved price movements in the banking sector is writ large. What this means is that as the economy improves, the greatest number of "good" surprises are likely to emerge from the banking sector!

And in this environment with no real, or at best uncertain, investment opportunities - one ought not to be surprised if the market rewards "good" surprises asymmetrically!

The columnist works for a major European investment bank in New York City. Opinions expressed here are his own and do not reflect the views of his company or Gulf News.