the big think

The Big Think

Imagine capital market decisions designed and implemented by the new thinking machines through multiple platforms of decreasing liquidity. 

Market participants outline the process for AI (40% of orders) through multiple platforms (each with independent software, hardware, legal agreements, and all market to model derivative pricing rather than mark to any approximation of market.)

Whatever the decision orders fitting through narrow pipes will have an exaggerated impact on price up or down.

For the time being the cycle has been virtuous (for the longs). 

The algorithm has been buy central bank quantitative, buy bonds because cbqe insures the next bid ($ 8 trillion in bonds have negative yields), and sell commodities

Equity prices are at at all time highs trading at multiples ranging from the incredible to the incredulous. 

Government bonds in certain markets offer the privilege of a return less capital than was committed. 

And the price of oil has been 30 % under its median price the last 3 years (50 against 75).

What could reverse the cycle ?

Not government data issued by the same governments printing the specie to fund the fiction. 

But oil could.

In the 5 year before Lehman oil ranged from 40 to 120. In the years since the median range has been 50. 

Were price to return to 70-80 it would be a statical reversion to the mean and not a significant departure from any trend.

But it would be an outcome not provided for in the thinking machines. 

Were oil to move 40 % higher what would the machines conclude for the path of interest rates, bond yields, equity prices, and the pricing of volatility in the $600 trillion universe of derivatives. ?

Take the example of a developing market country that is a large commodity importer.

The country imports 80% of its energy requirements and it is estimated that a  $10 change in the price of oil results in a .4% change in the GDP.

The average price for the country’s basket of energy is $60 today and were oil to return to median pricing (wti from 50-70) then the basket in turn would be priced at $80, a $20 increase, or -.8 % GDP as the crow flies

Strolling through the algorithm for equities in that country if GDP growth is assumed at 7% then corporate profits are expected to grow at 3x or 21% and equities would be priced at that multiple, take it at price to earnings ratio of 20 for the easy math

What happens if GDP growth is 5 % does the expectation for corporate profit growth decline to 15% and the price to earnings adjust accordingly ?

The country has been a the beneficiary of sentiment this year. The price to earnings ratio has expanded from 22 to 27 while earnings and growth have not kept pace. And this is before any potential turn up oil prices.

Historically buyers of equity in this market when the price to earnings ratio has exceeded 23 have been rewarded with negative forward returns (-10-25%).