How to Handle the Rise of the Machines By Alan Farley RealMoney.com Contributor 5/3/2007 12:42 PM EDT Multinational big-cap stocks are outperforming small-caps by a wide margin. This is a major problem for technicians, because we're taught that rallies narrowly based on the most-liquid issues are destined for failure. In fact, these types of uptrends often represent the last gasp in long-term bull markets. But I'm not ready to predict a secular downturn, because smaller stocks still have time to get their acts together and join the blue-chips at new highs. But it's something to watch as this curious spring market continues to unfold. In the meantime, it's a good time to raise cash and keep a generally defensive posture, despite the bullish headline numbers. Traders know what a tough market this really is, as waves of stealth selling pressure hammer the majority of our positions. This computer-driven activity is triggering some of the whippiest and most uncomfortable price action I've seen in years. Liquidity is also a myth these days, with bids well under the market vanishing on each downdraft. Rev Shark has done an excellent job in recent weeks pointing out the frailty in this twitchy tape. Indeed, you aren't making money this spring unless your efforts have been focused in a narrow range of opportunities. More likely you've gotten cut to shreds as technically sound stocks have ripped through logical stop-losses for no obvious reasons. We're also seeing a ton of "ganging" behavior, where hedge funds bully down prices on strong stocks at the open, hoping to shake out as many longs as possible. This type of manipulative activity isn't possible without a high degree of coordination between these folks. But that's illegal, isn't it? Oh never mind, I'm just being paranoid. In the meantime, we're seeing insane rallies, such as Amazon's (AMZN - commentary - Cramer's Take - Rating) 19-point slingshot last week. In normal markets, the public would drive this type of parabolic activity, not realizing that profits were dependent on quick and timely exits. However, the public doesn't seem to be participating at all in this latest wave of rocket launches. Rather, I suspect that institutions are pushing up these stocks, trying to play catch-up after the February nosedive. Performance is everything on Wall Street, and many of these folks are trying to get ahead of the curve as the summer months approach. Unfortunately, it looks as though the dynamic of supply and demand is taking a back seat in this odd parabolic sideshow. The public got scared out of the market in the first quarter and isn't likely to return until later this year, at the earliest. That's why sentiment numbers are lower than expected despite the Dow Jones Industrial Average's run to new highs. It's especially telling that Joe Sixpack doesn't care that the Dow is trading over 13,000. He's too busy trying to recover from the February selloff and would rather drink beer or play golf than fool around with the stock market this spring. Have you sat back and really thought out the Feb. 27 selloff? That session revealed a major structural weakness in the world financial markets. Algorithmic trading programs triggered that ugly event, instead of panicky human sellers. In fact, it might never have happened in a legitimate supply-and-demand marketplace. The session might be a precursor to a historic meltdown in the not-too-distant future. On that day, we found out that billions of program-driven shares can inflict serious damage when they're lined up on one side of the market. These cold lines of code are emotionless, so they remove classic greed-fear buying and selling behavior from price development. Then consider the impact of upcoming Regulation NMS, which will require trades to be executed at the best price available at the time, regardless of exchange. Institutions are now spending nearly $1 billion per year to upgrade their systems to speed up executions, bring the majority of business in-house and accommodate new rules. Add in penny options and experts predict that electronically driven volume will expand from 4 billion to more than 130 billion daily transactions by 2010. Unfortunately, the institutions building these futuristic systems don't have a real understanding of the potential consequences. So we're all at risk. Think-tank Tabb Group pointed out in a 2006 report that "as the algorithms become more complex, there is a danger that the interfaces will become cluttered and indecipherable." In other words, they're admitting the possibility of a doomsday scenario in which the worldwide trading systems go out of control. Unfortunately, the Securities and Exchange Commission is way behind the curve with these electronically driven markets. That means they'll be implemented in an essentially unregulated environment. It reminds me of a Cold War-era science fiction movie called Colossus: The Forbin Project, in which two electronic missile systems hook up and take over the world. How can relatively small market players deal with this nightmarish surge of automated trading? First, we need to throw away our market depth screens, because the vast majority of volume is being hidden from public view. Second, we need to jump back to the sidelines whenever price action defies the natural laws of supply and demand. Pretty price charts can't help us when program trading moves the tape in unnatural directions. And it's a mistake to try to outthink these complex strategies. There's a reason that institutions are recruiting top programmers from the nation's best colleges. They're hiring people to build algorithms that outthink human traders, like you and me.