On Wednesday last week, Fed chair Jerome Powell announced another interest rate hike. And naturally, we’ve all been paying attention to the market sell-off that’s resulted from the Fed’s move.
Yet immediately after Powell’s announcement, prices initially soared. When we look at a chart of the SPDR S&P 500 ETF Trust (SPY), the market action spiked and went nearly vertical…
Nearly 10 million shares were traded in a five-minute interval compared to the typical one or two million in the hours before.
With this action, the Dow rose 932 points, the S&P 500 gained 2.99%, and the tech-heavy Nasdaq Composite jumped 3.19% to end the day.
It was the biggest gain since 2020 for both the S&P 500 and the Dow.
While we may be tempted to see this as a fluke, this kind of extreme intraday market action tells us something important about how the markets work… And it’s something we should keep in mind as stocks tumble.
So why did stocks rally after the bad news broke?
It’s not because of a whale like Warren Buffett… And it’s not everyday investors like you and me causing it…
This kind of extreme market action is because of one thing: algorithmic trading – which is often used for “high-frequency trading.”
This may come as a shock to some. But between 60–73% of the trades that happen in the stock market are from machines – algorithms, to be exact. If we look at the crypto market, 80% of trades are machines. And the foreign exchange market is even higher at 92%.
And they’re programmed to buy, sell, and trade faster than even the best Wall Street trader around.
So when a big news headline breaks – like last week’s interest rate hike of 50 points – traders using these programs can react before anyone else. Hedge funds using these algorithms move huge chunks of money in and out of the market in milliseconds.
And in a matter of minutes, they can manipulate markets – legally.
Algorithmic Trading From the Great Recession Into 2011
Source: MIT Technology Review
The above graphic illustrates the increase in algorithmic trading following the Great Recession that spanned from 2007 to 2009. Starting in 2010, we can see the spikes of high-frequency trading go wild.
It spawned a whole new world in the stock market – the age of the machine.
The use of algorithmic trading has only increased over the years since then. And it’s expected to grow 11% year-over-year from now until 2026.
And as a result, we find ourselves in a predicament today. Algorithmic trading moves markets in minutes… And other investors have no hope of keeping up.
It’s critical as investors that we’re aware of this dynamic as the market falls.
Traders Are Popping the Champagne
Many investors are freaked out by the interest rate hikes. From last Wednesday’s peak, the SPY has fallen almost 7%. The Nasdaq is down 10%.
And we can be tempted to pull out our money and run for the hills when markets are trending down like this.
But these are the times when big hedge funds start popping champagne bottles in their offices. High-frequency traders at these firms can use these moments to make enough money to show huge gains for the entire year.
I’m talking about companies like Citadel, the massive hedge fund supporting the “free” brokerage Robinhood. Yet, nothing is really free.
These big hedge funds purchase our order flows from places like Robinhood. In fact, last year Citadel had contracts with nine online brokerages for their order flows.
Order flows allow you to see how other market participants are trading – what they’re buying and selling. And hedge funds buy these flows because they can profit by filling orders at one price. Then they go out and trade for themselves at an even better one.
It may only be a penny difference – or less – but these traders can make a big profit due to their scale.
And when the market is volatile like this, the spreads (the difference between the bid and the asking price) available to them get even bigger… which means they can positively rake in money.
Ultimately, this kind of trading amplifies the volatility we see and causes a cascading effect. As the market falls, more and more people rush for the exits… And these traders are more than happy to take advantage.
So what should we do in market conditions like this?
Our Path Forward
The most important thing – even though it may seem counterintuitive or uncomfortable – is to sit tight in these moments.
We are rapidly heading toward oversold market conditions. This is when all the sellers in the market are finally exhausted… When everyone who wants to sell has.
As I discussed in a recent essay, the Big Money Index (BMI) has dropped sharply. That’s my proprietary method of tracking buying and selling pressure of institutional investors. And it says we’re now right on the cusp of hitting oversold conditions.
At writing, the BMI has now fallen to 32.5. That means the bottom of all this will likely hit within a week or two if the market keeps on its current course.
And when we get to the bottom, that’s when the giants buy. The Warren Buffett’s of the world look at the bloodbath and run into the market when everyone else is running out.
This has been Buffett’s investment strategy since 1956. And it’s been his key to success in turning $174,000 into $124 billion in 66 years.
And if we’re wise, we’ll follow his lead and build our wish lists.
I know right now it hurts to watch the market drop. I know it from my own portfolio.
But we have to use these market conditions to our advantage. We can’t move with the crowd, or we’ll be swept away in a wave of selling.
We need to be strategic and wait… We need to watch for these rock bottom conditions. And let’s have our cash in hand ready to buy at the bottom.
Editor, Outlier Insights