Picking up on some negative waves

Bull markets are running on both sides of the Atlantic. Given that western stock markets are often forward-looking, recent advances suggest healthy economic growth in 2010. But will growth occur to the degree flagged by the stock market? The most recent batch of economic statistics raises some provocative questions.

In the UK, many experts believe the recession will end soon, assuming it has not already done so. Unfortunately, retail sales, house prices and the threat of rising taxes hint that any recovery will be weak. Recent US economic data also hint of sluggish growth in the year ahead.

Last Monday’s 1.4 per cent retail sales gain was boosted by the temporary “cash for clunkers” vehicle subsidy. Sales rose a miserly 0.2 per cent once vehicles were removed from the calculations.

Tuesday brought news that industrial production rose just 0.1 per cent. It would have declined if not for the replenishing of depleted “cash for clunkers” inventories.

Consumer sentiment is a more forward-looking trend. I typically treat it as a lagging indicator and am not too fussed about weak figures near the beginning of a new economic cycle. But this time is different.

One concern is that consumer sentiment unexpectedly fell last month after rising for several months in a row. According to Ian Shepherdson of High Frequency Economics, consumer confidence correlates to retail sales. The current score suggests a 1 per cent rate of sales growth in the months ahead.

Unfortunately, correlations between sentiment and sales assume a normal level of credit availability. But credit is very constrained, so sales growth might not rise in step with confidence.

The “future expectations” component of the confidence score also worries me. It fell last month in spite of declining petrol prices and rising stock market prices. These two elements are usually associated with rising confidence in the future. Consumers are uneasy.

Clearly, recent economic data and stock market gains are sending different signals. Experience teaches that they will eventually dance to the same tune. Perhaps the stock market has overshot. Or perhaps the stock market is flagging a strong economic recovery that will occur one or two years down the road. No one yet knows the outcome of this puzzle.

My view is that the stock market has overreached and will stumble. The problem is quantitative easing (QE) – central bankers flooding the economy with cheap money. Most experts believe this policy has triggered powerful price gains in many asset classes, including shares.

But western governments are increasingly worried about the long-term effects of QE. It is only a question of time until the stimulus is scaled back and this raises the question of how the stock market will react to the withdrawal of virtually free money.

I fear that shares will slip once QE is removed from the mix. The size of the drop depends on economic growth and recent data suggest growth will be weak.

Last week’s orchestrated announcements by several Federal Reserve governors that asset prices were not “massively overvalued” were significant. The Fed inadvertently confessed that it believes shares are overvalued, even if not massively so.

My view is that negative evidence is piling up. Longer-term investors might be disappointed by their equity investments in the not too distant future. But shorter-term traders need not be too stressed by this development. Trading opportunities occur in all phases of a cycle.

I often get useful clues about companies to buy or sell by monitoring statements issued by close competitors. Last week’s interim statement by Havelock Europa (HVE) is a good example.

The company is feeling the effect of economic weakness in several divisions. One glaring exception is a 35 per cent third-quarter revenue gain in its education division thanks to the government’s Building Schools for the Future programme.

News of this gain led me to RM Group (stock market ticker RM.), the category leader among companies that provide software products and services for classrooms. It will report 2009 earnings on Monday. If Havelock’s results are anything to go by, RM could be a market pleaser.

I think these shares are ripe for a bounce. RM is one of the few companies on my watch list that has not participated in the bull market. Prices are lower today than when the rally started last March.

Several signals point to a trend change. One good sign is that RM keeps landing profitable new government contracts. Most are multi-year programmes with ringfenced budgets so the current financial crisis will not affect them. Also, if last week’s pre-election headlines are to be believed, the government might even increase spending on education. My own view is that the Tories will have little choice but to match Labour education spending plans or risk being branded as heartless budget-cutters.

Another good sign is that many analysts forecast double-digit profit increases for the next few years. The facts will be known on Monday at 7am.

Stock market historian David Schwartz is an active short-term trader writing about his own trades and strategies. Send any comments or suggestions to tradersdiary@ft.com