Channel your energies in the right direction

An old stock market adage declares that shares always  move in the direction that disappoints the most investors. The current trend is certainly delivering according to this maxim.

Some traders, myself included, have shifted to a defensive stance in the last two months. The FTSE 100 gained almost 300 points since I began to cut back on trading activity and raise my cash levels.

Another group is probably even more frustrated than I am. They sat on the sidelines when shares rocketed up in the spring and summer rally. Anecdotal evidence suggests that some of these fencesitters moved into shares in the last two months.

Given that recent stock market gains were narrowly confined to a few sectors, many recent buyers have, at best, merely broken even.

So what lies ahead? My FTSE 100 graph provides a useful perspective. UK shares have been firmly entrapped in a rising trading channel for the last nine months.

There are important implications associated with this graph so I monitor it frequently.

Prices are currently near the top of the channel. History teaches that decisive breakouts through the top of lengthy channels are rare. But if they do occur, they typically precede a lengthy “blow-off” rally that is likely to run for months. Unfortunately, blow-offs usually come at the very end of a bull market.

So I am not predicting that a blow-off rally is about to occur. But if one did take place, it would probably be an opportunity to make substantial profits. I would then prepare for a lengthy period of disappointing trading conditions.

The bottom of a lengthy rising channel is equally important to monitor. Declines that decisively push prices through the bottom are usually followed by further pain for months, not weeks.

With both kinds of breakout, sustainability is the key. A brief spurt or dip that peters out after a week would not count as a decisive breakout.

It is too early to worry about either breakout alternative. The UK stock market appears to be well-entrenched within the rising channel. The boundaries on the Footsie are about 4,700 to 5,400.

Although shares are currently near the top of the channel, I would be very surprised if a blow-off rally actually occurred.

The economy is too damaged and will remain so for a substantial period. Also, the stock market is too dependent on government stimulus, which will probably begin to taper off next year.
Even so, proximity to the top of the channel makes this graph worth monitoring.

The likelihood of a steep decline is also becoming equally doubtful to me. Prices appear to be solidly supported by huge amounts of sidelined money waiting to pounce if prices dip.

If I am right on both counts, the only other possibility is for shares to drift sideways for the next few months. A move of
this type is consistent with that old saw that the stock market is hardwired to frustrate as many investors as possible. It is difficult
to devise a more frustrating scenario for bulls and
bears alike than a sideways drift.

Long-term investors are likely to be frustrated if my hypothesis turns out to be accurate. However, shorter-term traders can make solid profits when a choppy stock market causes prices to drift sideways.

As far as my own trading is concerned, I continue to keep my eyes peeled for shares showing above-average strength, especially in the aftermath of a negative news announcement that catches everyone by surprise.

One company that fits the bill is Innovation Group. It provides a range of claims processing services to insurance companies. I have traded these shares in the past and feel comfortable with the company’s business model and prospects.

Even better, there have been several recent takeover bids for the company. All have been spurned. The latest offer of 16p, roughly 50 per cent above its price at the time, was turned down last month on the grounds that it materially undervalued the company.

These repeated offers suggest that trade buyers continue to regard Innovation Group as a worthy acquisition target.
I suspect they will be back.

But this share is not a risk-free investment. The company has serious credibility problems.

City institutions have been uncomfortable since
it missed earnings forecasts a few years ago. Prices were savagely beaten
down from their mid-2007 peak.

It is also worth noting that the Innovation Group feels the effects of a broad economic slowdown and is in litigation with a division of Allstate, the US insurance giant. However, these issues have been well known to investors for at least 12 months and are probably already in the price.

The company addressed City concerns last week by announcing its chief executive had stepped down. The suddenness of the announcement, coupled with the fact that a headhunter had just been hired to find a replacement, suggests a first-class boardroom brawl occurred, not an orderly changing of the guard.

On the positive side, the company also reiterated that current profits would meet City expectations.

The shares promptly
lost almost 10 per cent after the announcement. But fresh buying quickly kicked in on very heavy volume immediately after prices approached their support line on the chart. By the end of the day,
the price was unchanged.

I view the heavy wave of buy orders as a strong sign of institutional satisfaction with the executive change. Several analysts have since suggested that the company is now “in play”.

So I think that the market just flashed a solid buy signal. In spite of the risks, I believe these shares have further to run.

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