Market Overview

Recent Market Rally a Sham? Algorithmic Trading Controlling the Market (USO, SLV, GLD, UUP, SPY)

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The S&P 500 has gained 101% from the low set back in March of 2009 (666.79). Even with yesterday's market plunge, the S&P is only 15% lower than its all time high of 1,576.09, which was set back in October of 2007. The question is why.

Has the economy really improved that much since the economic crisis to warrant this rise, or is something else driving the market higher?

Here are some of the current economic conditions:

1) Housing prices in the United States continue to freefall. Tuesday, the National Association of Realtors reported that the median price for single-family homes fell nearly 7% from the fourth quarter of 2010 to $158,700 – 4.6% lower for the same period last year.

The more home prices fall, the greater the number of borrowers who become underwater on their mortgages. This leads to an increase in the number of foreclosures and a continuance of the negative housing cycle.

2) The unemployment rate has rebounded a paltry 1.1% from its low of 10.1% set back in October of 2009, currently sitting at 9%. That 1.1% improvement is hardly in line with the 32% rise in the S&P over the same timeframe.

3) Commodity prices over the past year have been soaring. Oil prices have increased 31%. Gasoline prices have increased 45%. Silver prices have increased 91%. Gold prices have increased 25%. Food prices have been surging across the board, with corn futures recently hitting all time highs.

Gold and silver, which are historically gauges of fear and inflation concerns, have been rising right along with the indices – an extremely odd occurrence.

So how is it that an economy in such seemingly bad shape can have a strong market relative to historical comparisons?

The answer may lie in the rise of algorithmic trading. Unless you have been living under a rock, you know that since the late 90's, algorithmic trading has been steadily gaining prominence in the financial industry. High frequency trading (HFT) currently accounts for about 70% of all U.S. trading volume.

Computers, in essence, drive market direction. Investment banks and trading firms simply plug in formulas and computers execute trades based on certain parameters and conditions.

In speaking with numerous high frequency trading firms and traders in Chicago, the consensus seemed to be that the “trade of choice” since the market collapse has been based on the action in the commodities and currencies markets. When the market crashed, commodities crashed along with it, which was a nod to the slowing of the U.S. economy.

HFT firms and investment banks basically came up with the straightforward theory that a rise in commodity prices would signal an improvement in the economy. So, the algorithmic trade was set (If X, then Y).

The formula and reasoning looks something like this:

Higher commodities prices = growth = strong market.

Weaker Dollar = Higher commodities prices.

Algorithm = When dollar falls, buy commodities. When commodities rise, buy market indexes.

To illustrate this, just compare one year daily charts of the EUR/USD, S&P 500 (SPX), oil futures (/QM), silver futures (/SI), and gold futures (/GC). All of the charts look nearly identical. If you use ETF's, compare PowerShares DB US Dollar Index Bullish (NYSE: UUP), SPDR S&P 500 (NYSE: SPY), United States Oil Fund (NYSE: USO), iShares Silver Trust (NYSE: SLV), and SPDR Gold Trust (NYSE: GLD).

Another example occurred on the day of the “flash crash.” The dramatic transpiring events in Greece threw the euro into a freefall. That plunge triggered computerized index selling programs, which flooded the market with sell orders simultaneously, causing drastic price decreases across the board. It is amazing that after numerous hearings, the “experts” on Capitol Hill still have not cited algorithmic trading as a main culprit.

Virtually the same thing happened on Thursday of last week, just not on as large of a scale. The U.S. dollar gained over 1%, and selling programs proceeded to trash commodities and indices.

Starting to notice a pattern?

An executive at a prominent trading firm in Chicago who wished to remain anonymous stated in a recent interview, “The problem with the current algorithms, which are obviously taking their lead from the dollar, is that the formula being used is fundamentally flawed. If the rise in commodities prices was due to strong demand and/or economic expansion, that would be one thing. That is not the case, though. The index gains are directly related to the decline in the U.S. dollar and nothing else. It's a sham, a straw house – and it is only a matter of time before it collapses.”

He added, “There was a time when you could look at the market and it was reflective of the overall economy. Sure, the market was irrational at times, but it always came back to reality. Actual people were doing the research and making the calls in real time. That is not the case anymore. The computers that are running the market, at my firm included, don't care about fundamentals. They exist for only one thing - to generate profits. It pretty much kills any credibility the market has.”

The executive ended the interview by saying, “I've been trading for over 20 years, spending a lot of that time in the pits. I used to have actual reasons for what I was doing. It was pure, and it made sense – at least it did to me. Now we've got computer programmers working here who have no real fundamental understanding of markets or the economy whatsoever, and somehow they create programs that make tons of money – and it's the same across the industry. It is actually pretty scary.”

Europe is taking significant steps to ban high frequency trading, as noted in this article from Zero Hedge.

Although, U.S. regulators and politicians have made sharp public criticisms of the practice, little has been done to put it to an end.

Time will tell how the algorithmic trading phenomena will play out, but if recent events are any indication, it will not be pretty. Till next crash……

 

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