he UK stock market has drifted sideways for 11 months.
This claim might surprise some investors. The confusion is caused by oil giant BP. Its shares plunged steeply after the Gulf of Mexico oil spill, pulling the FTSE 100 down as well.
Our chart shows the FTSE 100 trend with BP eliminated after April 20 – the date of the oil spill. Without BP, the sideways drift of the “Footsie 99” is quite evident.
This lengthy drift is frustrating. I trade best when I have a point of view about the future. Unfortunately, the UK stock market rarely drifts sideways for this long so I have no historical guidelines to turn to.
Other predictive indicators have consistently disappointed me in the past. A systematic review of their effectiveness often reveals serious reliability problems.
Another problem is that success in the “prediction business” is a temporary phenomenon. Every successful indicator eventually loses effectiveness.
Why do winners eventually fail? The main reason is that we humans are very adaptable creatures. We are quick to change our behaviour.
Imagine that you plan to buy shares in the next week or two and a trusted market-timing indicator just flashed a “buy” signal.
Wouldn’t you advance your purchase by a few days to catch the expected gain?
As other investors follow suit, money flows that initially created the profit window get altered. These changes eventually kill the trend. Recall the old adage that success breeds failure in the world of investing.
The only way to counter this problem is to find new predictive tools and recognise that they will eventually run out of steam.
And I reckon I have just spotted a fresh indicator that has done a fair job of predicting healthy UK stock market bounces in recent years. It is based on a weekly survey of US investors that is sponsored by the American Association of Individual Investors.
Their online poll asks association members a single question: are you bullish, bearish or neutral about US stock market prospects for the next six months?
My initial reaction was to doubt that a survey of US private investors could forecast UK stock market swings. This US poll poses other problems as well. It does not represent the opinions of all US investors, only those association members who choose to respond. Market researchers are typically scathing about polls based on non-representative and self-selected samples.
But, in spite of these criticisms, I experimented with the data. To my surprise, I came up with a useful UK stock market indicator by dividing the percentage of respondents who are positive about the future by the percentage who are negative. Neutral investors are ignored.
There were five periods in the last 20 years when the ratio of positives to negatives sank to 0.37 or lower before beginning to recover. Or, putting it another way, at worst there were only 37 bullish investors for every 100 bears. But low readings of this magnitude proved to be a very positive sign.
The UK stock market typically rose sharply in the next few months. Four of the five “buy” signals were followed by rallies in the 28-66 per cent range within a few months.
A single failure occurred in 2008 in the midst of a painful bear market downturn. Continued fears about the health of the world’s financial system overwhelmed the signal.
Of course, no indicator is perfect but this one shows some early signs of promise. Even better, the ratio of US bulls to bears recently fell to 0.37 before bouncing up – the sixth signal in the last 20 years.
So far, the UK stock market has risen by 14 per cent since its July low. There are no guarantees, of course, but if the past is any guide, there is a fair chance that this rally has further to go.
Stock market historian David Schwartz is an active short-term trader writing about his own trades. Send any comments to email@example.com