Bull markets require volume, lots of it, and breadth: for the market to be moving across multiple sectors. This latest rally (which has the bulls braying that a new bull market is here) has neither.

As you can see, volume on the S&P 500 first peaked in March and has since fallen dramatically. However, even this picture is far rosier than reality when you consider that High Frequency Trading Programs account for 70% of all trading on the NYSE.

For starters you should know that most indexes or exchanges offer a ¼ of a penny rebate for broker dealers who put in orders. So simply putting in an order, even if there’s no profit made on the price, can make a ¼ of a penny in profit.

Let’s say an institutional investor has put in an order to buy 15,000 shares of XYZ company between $10.00 and $10.07. The institution’s buy program is designed to make this order without pushing up the stock price, so it buys the shares in chunks of 100 or so (often it also advertises to the index how many shares are left in the order).

First it buys 100 shares at $10.00. That order clears, so the program buys another 200 shares at $10.01. That clears, so the program buys another 500 shares at $10.03. At this point an HFTP will have recognized that an institutional investor is putting in a large staggered order.

The HFTP then begins front-running the institutional investor. So the HFTP puts in an order for 100 shares at $10.04. The broker who was selling shares to the institutional investor would obviously rather sell at a higher price (even if it’s just a penny). So broker sells his shares to the HFTP at $10.04. The HFTP then turns around and sells its shares to the institutional investor for $10.04 (which was the institution’s next price anyway).

In this way, the trading program makes ½ a penny (one ¼ for buying from the broker and another ¼ for selling to the institution) AND makes the institutional trader pay a penny more on the shares.

You’re probably asking, “How can HFTPs do this? Doesn’t the SEC or someone else regulate them?” Fasten your seatbelts… coming will probably blow your mind…

HFTPs are tapped into the actual electronic stock exchanges (the NYSE, Nasdaq, etc). Put another way, they have access to any and all trades that occur on the stock market. In fact, they’re usually a few microseconds ahead of ANY trade ANYONE makes. And I mean anyone (you, me, Warren Buffett, hedge funds, etc).

These programs don’t analyze financial statements or charts… they’re designed to simply access the information that is being transmitted across an electronic stock exchange, and then insert themselves between someone’s order and the actual electronic market makers (the programs that connect buyers and sellers).

How do they do this?

By having their servers set up within a quarter mile of the ACTUAL exchanges (NYSE, Nasdaq, etc).

When it comes to transmitting information online, server and network speed can only take you so far. And when you’re dealing in microseconds, actual physical location between servers can make ALL the difference in the world.

So HFTP firms ACTUALLY have their servers housed in buildings located as closely as possible to the buildings housing the NYSE’s servers. This might only mean 0.0001 second’s worth of difference but that 0.0001 second is all that’s needed for an HFTP to step in front of your order to the NYSE for 10 shares of Bank of America, push the price up a penny, and collect a ½ cent rebate in the process.

Now comes the truly horrifying part. ALL of this is 100% allowed, supported, and endorsed by the actual stock exchanges: the NYSE, Nasdaq, etc. These exchanges make money based on the number of transactions occurring. So adding a few middlemen to traditional buy/ sell transactions is A-OK. It’s all for the sake of “increase liquidity.”

And this kind of nonsense now comprises 70% OF ALL MARKET TRANSACTIONS.Put another way, the market is now no longer moving based on REAL orders, it’s moving based on a bunch of HFTPs gaming each other and REAL orders to earn fractions of a penny.

I don’t trust this stock rally for a minute. The fundamentals simply don’t support it. The market’s move have become entirely technical in nature. So I wouldn’t be surprised to see the S&P 500 test 1,000 in the next week. But once it does, LOOK OUT BELOW.

Bull markets require REAL buyers making REAL orders, not computers gaming one another for ½ penny profit.

I’ve prepared a FREE Special Report detailing three investments that will soar when the Second Round of the Financial Crisis hits. I call it the Financial Crisis Round Two Survival Kit. Swing by www.gainspainscapital.com/roundtwo.html to pick up your free copy today.

Good Investing!

Graham Summers

http://gainspainscapital.com

Graham Summers: Graham is Senior Market Strategist at OmniSans Research. He is co-editor of Gain, Pains, and Capital, OmniSans Research’s FREE daily e-letter covering the equity, commodity, currency, and real estate markets.

Graham also writes Private Wealth Advisory, a monthly investment advisory focusing on the most lucrative investment opportunities the financial markets have to offer. Graham understands the big picture from both a macro-economic and capital in/outflow perspective. He translates his understanding into finding trends and undervalued investment opportunities months before the markets catch on: the Private Wealth Advisory portfolio has outperformed the S&P 500 three of the last five years, including a 7% return in 2008 vs. a 37% loss for the S&P 500.

Previously, Graham worked as a Senior Financial Analyst covering global markets for several investment firms in the Mid-Atlantic region. He’s lived and performed research in Europe, Asia, the Middle East, and the United States.

© 2009 Copyright Graham Summers - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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