Do Machines Control the Stock Market?

You don't have to be a sci-fi movie expert to know that when humans and machines clash, things usually go poorly for the flesh-and-blood faction. Just think back to The Matrix (the first one, not those god-awful sequels) to see what I'm talking about.

So you can imagine my concern when I learned that perhaps as much as two-thirds of daily equity trading volume is the result of orders placed by -- you guessed it -- machines.

Rage against the machines
According to a recent Wall Street Journal article, "the majority of stock trades now originate with fully automated 'high frequency' funds." These funds "trade in and out of stocks at light speed without human intervention," making a minuscule profit on each transaction. This is all made possible by market centers like the New York Stock Exchange, which pay these high-frequency funds a tiny rebate for each filled order in order to facilitate liquidity.

That might not sound like much of a strategy, but it becomes quite lucrative when you jack up the trading volume. And apparently, that's exactly what high-frequency funds have done over the past year and a half.

Proponents of high-frequency trading claim that the heavy volume helps keep bid/ask spreads low, helps buyers and sellers find a mutually agreeable price, and reduces price volatility. However, a report from Themis Trading blames high-frequency trading for skyrocketing stock market volatility.

That's consistent with the WSJ article, which claims that "with the rise of these automated funds, the stock market is more prone than ever to large intraday moves with little or no fundamental catalyst."

Now before you start smashing your kitchen appliances, bear in mind that machine-based high-frequency trading wasn't solely responsible for those large intraday moves.

While it's far more convenient to place the blame on fast-trading machines, we can also thank hedge fund deleveraging, mutual fund redemptions, and a panicked (human) investor populace for the astonishing market volatility over the past 18 months.

That's right, I said thank
You see, while short-term stock price volatility can be tough for our all-too-human emotions to handle, it can also create tremendous buying opportunities for long-term investors. That's what Lord Abbett senior economist Milton Ezrati reported in a paper called "How to Stop Worrying and Learn to Love Volatility."

According to Ezrati, regularly adding new money in a volatile market allows an investor to purchase more shares at cheaper prices, thus lowering the effective cost basis. Interestingly, Ezrati's findings hold true whether prices are rising or falling.

Where the volatility is the worst
Take a look at the share price fluctuations for these steady, stable companies over the past 52 weeks, none of which have had significant fundamental issues:

Whether they're because of machine-originated trades or not, those are some pretty serious share price drops for companies of this caliber. But that volatility is nothing compared with the shifts seen at the smaller end of the market-cap spectrum.

Think small to win big
The recent stock market volatility has created some incredible buying opportunities for long-term oriented, fundamentals-focused investors -- particularly in the small-cap space.

Consider Dynamic Materials, a Colorado-based company that uses controlled explosions to bond different types of metal together (cool, huh?). Because the primary industries that Dynamic Materials serves -- energy, metals, and shipping -- were suffering, the company's stock price was beaten down to bargain-basement levels this spring.

But rather than dwell on the declining share price, the team at Motley Fool Hidden Gems focused instead on Dynamic Materials' fundamentals. They saw diverse revenue streams, strong customer relationships, a top-notch management team, and a balance sheet strong enough to withstand a temporary downturn in demand. Best of all, the team concluded that the share price grossly underestimated the company's intrinsic value.

That's why the team decided to take advantage of the market volatility and buy shares of Dynamic Materials. So far, that appears to have been a smart move -- the position is up 90% in less than four months.

The best is yet to come
Whether it's because of machine-originated trades or good old human over-reaction, stock market volatility gives rational investors the opportunity to buy companies at steep discounts to intrinsic value.

To see how the Hidden Gems team plans to profit from this volatility next, simply click here for a free 30-day trial to the service. There is no obligation to subscribe.

Already subscribe to Hidden Gems? Log in at the top of this page.

Rich Greifner hopes there is a special spot in hell reserved for Michael Bay. Rich owns several transformers, but none of the companies mentioned in this article. The Motley Fool owns shares of Dynamic Materials and Under Armour, which are both Hidden Gems picks. Under Armour is also a Rule Breakers recommendation. Coca-Cola and 3M are Inside Value selections. Coca-Cola is also an Income Investor pick. The Fool has a disclosure policy.