Farsighted focus gives a prettier picture

I am quite bullish about the future. In spite of the huge advance we have enjoyed since March, I believe this stock market rally has much further to go.

History provides strong supporting evidence. During the last 100 years, there were 18 downturns when the UK market fell at least 20 per cent. The typical bull market rally that followed each downturn ran for more than three years. All but one ran for at least one year.

The single exception occurred in 1957. A seven-month rally suddenly ended when sterling collapsed. Investors ran for cover when it became clear that base rates would rise by a painful amount.

Economic conditions surrounding the other 17 bull markets varied. Some occurred during periods of expansion. Others were enjoyed as the economy stagnated. But regardless of the state of the economy, the market always rallied for at least one year.

Recall that the current rally is now just seven months old. If history is a guide, it has further to go.

Morgan Stanley strategists recently studied the longevity issue from a different angle. Their research covered all major stock markets and used different definitions than
I did to define a bull market, when it began and when it ended. But their conclusion was the same. In the aftermath of big market declines, bounce-back rallies virtually always run for more than a year.

Given today’s worldwide economic problems, prospects for a rate rise in the immediate future are low. In fact, the Federal Reserve announced last Wednesday that rates would stay exceptionally low for an extended period. If its recent pronouncement is to be believed, the bull market of 2009 should continue to run into 2010.

However, while I am quite positive for the months ahead, my view for the next few weeks is more uncertain. As regular readers may recall, I strongly believed the stock market was ripe for a temporary dip earlier this month. I had informally pencilled in good prospects for a decline of 5-10 per cent.

My short-term expectations were completely wrong. Shares rose throughout September.

In spite of my error, I continue to be extremely concerned about the near-term future. Several factors worry me. Shares now appear to be struggling to gain further ground.

Also, history teaches that prices rarely move steadily in a single direction for long periods. And we must not forget the behaviour of private investors whose trading activity suddenly spurted and now exceeds levels last seen in the 1999 dotcom bubble.

I find it difficult to trade rationally and objectively when my emotions steer me in one direction but stock-market price action sends the opposite message.

I have responded to this puzzling turn in events by cutting back on my UK equity exposure. I now sit with 50 per cent of my funds in cash and have cut back on the number of new shares that I have purchased in the last few weeks.

This strategy may cause me to miss some gains but I shall sleep better when prices fall sharply like they did last Thursday.

My single recent investment was in Harvey Nash, the recruitment company. It is thinly traded so I made several small purchases over several days to avoid triggering a price rise with one larger purchase.

Unlike other companies in its sector, Harvey Nash is not a “pure play” recruiting company. It also does IT outsourcing for companies that do not
wish to hire permanent
IT staff.

IT outsourcing is a two-edged sword for Harvey Nash. It generates steadier profits than traditional staff recruitment during all phases of the economic cycle. But profit margins are lower. Some analysts are turned off by these lower margins and gravitate to other pure play recruiters. My view is different. I value steady revenue flows during uncertain economic times such as these.

The price graph tells its own positive tale. Fans of technical analysis will recognise a well-defined “head and shoulders” bottom pattern. Trends such as this often precede healthy follow-up rallies.

I also believe Harvey Nash is a potential takeover target in the not-to-distant future. There is a definite move toward industry consolidation. Spring Group was recently taken over at a whopping 69 per cent premium to the existing share price.

Harvey Nash would be a good fit for several competitors. Its range of worldwide offices can easily fill some gaps in the acquirer’s geographic coverage. The company’s price/earnings ratio is currently around 5. Comparable figures for major competitors are in the 9-14 range. This disparity makes an acquisition quite affordable. It also offers scope for a significant share price improvement even if no acquisition occurs.

Harvey Nash issues its first-half figures next Wednesday. I expect the report will make for painful reading. But share prices have steadily risen in recent weeks. It leads me to believe that very bad short-term news is already built into the price.

Analysts tell me that institutions will not be too concerned about Harvey Nash’s short-term performance. They are more interested in its forward view. If the company reports signs that the downturn in its recruitment business has levelled off, its shares might bounce. Fingers crossed.

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