Mixed signals put me on a tightrope

The stock market is sending mixed signals and I am growing increasingly uncertain about near-term prospects.

On the positive side, investor sentiment is improving. The sense of gloom so prevalent a few months ago is now absent. Even those who believe the 2007-9 bear market is not yet over acknowledge that shares might rise further in the near future.

Reputable forecasters are also growing more positive. Morgan Stanley’s strategists see a growing likelihood that economic improvement in the months ahead will exceed expectations. They base their call on a slew of economic indicators, not just the familiar headline makers. Data series such as the New York State manufacturing index, used car prices, loan growth in China and recent scores on the VIX index (commonly referred to as the Fear Index) all point in the right direction.

Two of my own historical databases also are flashing upbeat signals. The trend for the week ahead is quite positive. Since 1991, the FTSE 100 rose 17 times from July 28 to August 2 versus just one decline. A trend such as this does not offer a 100 per cent guarantee but it signals the presence of a positive bias to share prices around the end of the month.

The August trend is also favourable. There have been 23 years since the mid-1970s when a bull market was running as August began.  Prices rose during the month in 21 of those years. One of the two exceptions was in 1997 when shares fell by less than 1 per cent.

As regular readers know, I am quite positive about stock market prospects for the next six to 12 months. So, given my predisposition, these August statistics are very comforting.

But stacked up against all the positives are three significant negatives. One is illustrated by the chart. The UK stock market has drifted sideways in a broad trading range for 10 months. Every attempt to break through the top of the trading range failed and prices reversed. We now sit near the top of the range. The situation is ripe for a painful short-term reversal that could pull shares down by 10 per cent.

Another concern is that I now find it increasingly difficult to spot good trading targets. I favour beaten-down shares with a good story to tell. There were many such opportunities in March to May. Now, there are few.

A shortage of trading candidates could merely signal that it is time to switch investment strategies. There is nothing odd about this possibility. After all, different sectors or shares often react in different ways to a changing economic or political landscape. Traders must constantly change with the times.

On the other hand, the fact that many former bargains are now fully priced might also mean that shares are not likely to rise much further in the immediate future.

My third concern is linked to the unreliability of short-term directional indicators. Experience teaches me that when everyone expects A to occur next week, Z often occurs. In fact, short-term bullishness often occurs in the aftermath of a rally. Given the recent stock market spurt, today’s bullishness for the future might be a lagging indicator not a leading one.

So what lies ahead? I view the evidence as finely balanced. An added concern for me is anecdotal evidence that huge piles of money are sitting on the sidelines. Should the stock market decisively penetrate through the top of the trading range, a buying panic might erupt as formerly fearful investors suddenly rush to jump aboard a moving train. The thought of missing what could be the most powerful rally of 2009 is a major worry for me.

For the moment, I continue to trade but I am extremely watchful and stand ready to close down many of my profitable positions in a flash.

As far as my own trades are concerned, I have just retuned to Asterand, a small supplier of human tissue to pharmaceutical companies. Edison Research estimates that sector revenues are growing by 20 per cent a year. Asterand claims to be growing much faster.

The company is the largest player in this niche segment of the pharmaceutical industry. But its market share is merely 3-5 per cent so there is considerable room to grow. Asterand’s strategic goal is to grow in order to achieve economies of scale and greater pricing power.

Its management regards the current economic slowdown as an opportunity to satisfy its long-term growth targets. Industry sources believe it is actively seeking acquisitions.

Will Asterand deliver on its long-term objective? This is the $64m question.  So far, things are looking good. The current management team was only installed a few years ago. The performance of this loss-making company soon began to improve. Asterand now has 11 global agreements with major pharmaceutical companies. Seven were signed in the past year with the most recent one announced last week.

The company completed a huge one-off contract for the US government last year that flattered 2008 figures. Profits from that contract might confuse some investors into thinking that the recession has hurt 2009 earnings.  Not so. Excluding the one-off contract from the figures, next month’s statement will probably show that core first-half revenues and pre-tax profits rose sharply. There is a seasonal skew to the business so I expect an even stronger performance in the second half.

The price chart provides other optimistic clues about Asterand. When the price touches the 100-day moving average, it seems to trigger powerful rallies. One such bounce is underway right now.

Also notice that the shares more than doubled after interim results were released last August. Strong bounces also occurred in November 2008 and March 2009 after other upbeat statements. My impression is that investors do not closely monitor this company and wind up chasing its shares every time good news hits their screens. With luck, history will repeat itself.

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