A Computer-Driven Stock Market

Michael Maiello, 04.17.09, 03:00 PM EDT

We're in the midst of a nice rally, but is it all just penny-snatching algorithmic traders at play?

Despite continued bad economic news, the U.S. stock market has shown some signs of resilience and could potentially post its sixth straight week of gains. This has investors like Vince Farrell, chief investment officer of Soleil Securities, speculating that though the market's bottom will be tested in the coming months, the worst is behind us.

The current rally is reassuring -- it's based on steady and improving trading volumes and the CBOE Volatility Index, sometimes known as the Fear Gauge, has dropped steadily as market prices have risen. It's not at 34, still high by historical standards (history says that the VIX's upper limit was usually around 20) but unless we're headed for some serious mean reversion, the historical standard might need to be revised. The VIX was up around 80 at the end of 2008, which is bound to skew some averages.

Despite improving conditions, investors should be cautious. Timothy Mahoney, chief executive of BIDS Trading, the only dark pool of liquidity that has a partnership with the NYSE Euronext ( NYX - news - people ), says that much of the volume that's supported the current rally is coming from algorithmic trading programs that are "high-frequency computer-driven trades made by people attempting to capture spread."

A dark pool is a private marketplace where institutional investors can anonymously trade large blocks of stock. In lieu of using dark pools to move big stock positions, institutions can use computer programs to leak buys and sells into the market place in little bits, preserving anonymity and creating the chance to make money by capturing the usually minute difference between bid and ask spreads.

Mahoney believes that up to 70.0% of the market's current volume is represented by such algorithmic or opportunistic traders. That means that the market isn't necessarily doing what we tend to think it does -- weighing the prospects of an economic recovery six to nine months down the line.

"It's been widely reported that there are high levels of cash in mutual funds and excess cash from retail investors in money market accounts and institutional cash on the side," Mahoney says.

When that money comes back into the market, the volatility index will fall; some of the algorithmic trading that makes up the volume will be displaced, as spreads narrow and arbitrage opportunities dissipate; and the market will once more take on its function as a measuring stick for the world's economic prospects.

"Real [long-term] investors haven't made their decisions yet," Mahoney says. "They're waiting to see change."

If Mahoney is right and we're in the midst of an algorithm-driven rally, it could well dissipate with little warning. Investors with short-term horizons should beware.