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Understanding the Millisecond Market

In early January, half of the Americans polled by Gallup said that investing $1,000 in the stock market right now would be a bad idea. But half of Americans have been saying that same thing for years and have missed out on a huge bull run with record highs. Have equity markets become a proverbial no-man’s land for much of this country? Well, technology continues to make investing a game for pros who can keep up with the changes of how the game is played. State of the Markets explains…

Given the title of today's market missive, we could really go a couple of directions.

We could certainly talk about the fact that the tone of the stock market appears to have turned on a dime with the change in the calendar. The end of 2013 has meant the disappearance of the ho-hum days when stock indices simply advanced four out of five sessions and rarely pulled back for more than a couple consecutive days.

Out With The Old and In With the New

Out with the old and in with the new appears to be the case now. Gone are the low volatility advances. Gone is the idea of Mom and Pop getting back in the game. And gone too is the idea that a better-than expected economy would simply drive prices higher indefinitely.

2014's market is all about worry. Worry that the emerging markets will do what they tend to do every decade or so – implode and take the rest of the world down with them for a while. Worry that the economy is hitting yet another speed bump thanks to a lackluster holiday shopping season and the miserable winter that is ravaging much of the country. And finally, worry that the Fed is either dropping the ball or behind the curve. Both arguments seem to work, so feel free to take your pick!

Frankly though, the jury is still out on whether or not the 5.75 percent decline we've been treated to so far in 2014 will wind up being something meaningful or just another garden-variety pullback. And today's Nonfarm Payrolls report may actually go a long way toward settling this score.

Let's Talk Big Picture Changes

So, instead of trying to figure out what the next 3 to 5 percent move in the venerable DJIA might look like, let's turn our attention to the big-picture changes in the market environment that is occurring.

Perhaps though, the word environment may not be best. No, what we're really talking about here is the idea that the character of the market has changed over the last year or two.

All Algos, All The Time

Don't fret, this is not going to be another rant against HFT or the idea that the big banks/funds manage to make money in the stock market every single day of the year. Been there, done that. No, the primary purpose of this missive is to deal with what IS happening in the market these days and to plot a course of action.

The first point to be made is that the algos are here to stay. Let's face it; computers are better at executing stock trades than humans. There are no "fat finger" errors with computer algorithms and computers don't click the buy button when they meant to sell. So, the bottom line is that the idea of computers executing trades faster than you can blink isn't going anywhere.

Heck, we actually use algorithms all the time to implement our trades for clients. Why try to buy the SPY at one specific point in the day when you can let a computer break up the trade into itty-bitty chunks and execute it every few seconds for the rest of the day?

Actually, this is not the type of "algo" that we referring to today. We're talking about what used to be called "program trading," where computers jump in and out of the market at the speed of light trying to catch the latest trend in the market.

How Many Milliseconds Are There In a Day?

Today there are "ignition algos" that attempt to ignite a trend out of nowhere. There are also "trend following" algos that simply try to hop onboard an intraday trend and enjoy the ride until it ends. Remember, there are an awful lot of milliseconds in a single trading day (do the math, it is mind boggling!).

Think about this for a moment. If you have the ability to trade on a millisecond basis, each and every trading day represents the equivalent of years of trading opportunities compared to the old-school time frames of days and weeks. Therefore, more and more sophisticated, high speed traders are entering the game every year.

Today there are "ignition algos" that attempt to ignite a trend out of nowhere. It is this concept of computer-driven, trend-following algos that appears to be changing the character of the market.

The Result Is…

When a bunch of trend-following algos start chasing each other's tail, the end result is an increase in the size of daily moves. For example, was a weaker-than expected ISM report really worth 300 Dow points? Maybe, maybe not. But if you were watching the intraday action on a 1-minute basis, it was obvious that the computers just kept doing their thing all day long on Monday.

The key is that these trend-following algos feed on one another. Thus, intraday moves become exaggerated. Moves that a few years back may have taken 2-3 days, now occur in one (or less, often a lot less).

When an important piece of news comes out, the algos are on it – instantly. A lot of times the computers get it wrong though, because they can't actually interpret headlines. Fed Days are a perfect example of this concept. Within seconds of the FOMC statement, the S&P 500 will spike big – oftentimes in both directions as the computers adjust. However, once a trend is established, the trend-following algos tend to pile on.

These days, a news item isn't even required for the algos to get things moving. Algos know where the big moving averages are. Algos know where key support and resistance zones are. So, if an important technical level is breached in either direction, BAM! it's game on.

The Key Point

The key here is to understand that daily price action is becoming more and more exaggerated – again, in both directions. Once the algos get on a roll, they often just keep going until the closing bell rings. Then traders come in the next day and start all over again.

If you pay attention to the market's intraday actions on a 1-minute or less basis, you have to agree that these moves can come out of nowhere and before you can refill your coffee cup, the S&P has moved 0.5 percent. And what's important is that there generally isn't a visible catalyst (well, not visible to mere humans anyway).

Remember, we're not complaining about the computers here. Algo-driven trading is fine, fair, and completely legal. No, the key point being made today is that investors need to recognize that the game is changing.

State of the Markets publishes some of the financial world’s best commentary every single trading day. Read more here…

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David Moenning is the founder and chief strategist of State of the Markets. David began his investing career in 1980 and became an independent money manager in 1987.

In 2005 he launched State of the Markets and oversees investing products such as The Insiders Portfolio, Daily Decisions, and the IRA-401K Advisor (all available through WallStMavens).  David also works as a full time money manager, and is the President and Chief Investment Strategist of Heritage Capital Management, an RIA firm based on Chicago.  

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