Algorithmic Trading is the Only Reason Why Markets Keep Going Higher

Disclaimer– This article is for informational purposes and does not constitute financial advice.  Please consult with your financial advisor before making any investment decisions.  Please read full disclaimers here

Another day and another round of disappointing economic news, but mysteriously, the stock market continues to trade higher.  Let’s take a look at today’s economic news for example.  This morning, we received two major economic data points, the May Markit Manufacturing Flash PMI and April Existing Home Sales.

Similar to recent months, both data points missed expectations by a wide margin.  The Markit PMI Flash came in 53.8 vs. expectations for 54.5.  Existing home sales came in at a -3.3% decline vs. expectations for a 1.0% gain month over month.  And remember, March was supposedly impacted by bad weather!  So what’s the excuse now for bad April home sales?

In a world without central bank handholding and zero percent interest rates (which used to exist back in the day), the stock market would have traded down on negative economic news as this would have been a precursor to lower earnings.  However, in today’s Federal Reserve dominated financial markets, the S&P 500 immediately traded higher as soon as this data was released.

Take a look at the chart below.  The PMI number was released at 9:45am and the Home Sales number was released at 10:00am.


You will notice that the markets immediately trade higher after the disappointing data and then never look back.  So today, I asked myself, what type of investor immediately buys the market on disappointing data?  I don’t know any fundamental institutional investors that would play this game.  I also don’t believe retail investors sit by their computers waiting to buy the market on disappointing news, and even if they did, the collective buying power of retail investors is simply not large enough to the move the market this dramatically.

By process of elimination, we are left with only one group of investors, algorithmic traders.  By many measures, algorithmic traders have become a very large percentage of daily trading volumes.  I’ve seen estimates that algorithmic (or high frequency) trading constitutes up to 50% of daily volumes.

So, the question is why do algorithms buy when there is disappointing data?  When you begin to ponder this question, it becomes abundantly clear – algorithms buy on disappointing data because this strategy has worked repeatedly since 2009!  In fact, if someone told me to design an algorithm today to trade the market, I would design buy orders to execute on 1) any miss of economic data relative to expectations and 2) any indication that the Federal Reserve is delaying interest rate hikes.

The Federal Reserve has given algo traders a fail-proof trading methodology for the past seven years, so of course, algo traders will continue to push markets higher the longer we have zero percent rates or indications that rates will stay at zero.

So what does this mean for the rest of us?  It likely means that so long as economic data continues to disappoint, then, rates will continue to be at zero and markets will continue to trade higher until we are in a true bubble.  However, this is an immensely dangerous game akin to a Ponzi scheme.  I don’t know what will trigger the scheme to collapse.  It could be that we actually get a string of positive economic news, leading to a first rate hike.  It could be that the markets reach such atmospheric valuations, that it collapses under the weight of its own over-valuation.  Or it could be some other exogenous factor that none of us are thinking about today.

But my investment strategy hasn’t changed– invest with caution.  Buy safe stocks at attractive valuations.  And keep capacity to buy stocks on market corrections.

Categories: Investment Strategy

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