When a stock has collapsed in value it doesn’t take much good news for the shares to rebound, as witnessed by the performance of ASOS (ASC). The key challenge for investors now is to decide if this is the start of a proper turnaround or just another unsustainable bounce.

The fashion retailer soared by 28% over two days after reporting a ‘significant improvement in profitability’ (12 January). That was enough to reignite the market’s interest following a disastrous period for the stock.

ASOS’ share price fell 91% between April 2021 and October 2022 to 510p and despite an autumn recovery the stock began 2023 back at that level. It has suffered from competition, slowing growth, warehouse issues and supply chain problems.

Despite the upbeat comment about improving profitability in its latest trading update, ASOS is still suffering from a decline in sales, falling gross margins and negative free cash flow. The latter represents cash generated from operations minus the money needed to keep a business going. What’s left is used to pay down debt, fund dividends or share buybacks, make acquisitions, and invest in new ideas.

New chief executive José Antonio Ramos Calamonte is only seven months into the job and like anyone in his situation is offering promises of change and improvement. He’s in a honeymoon period where any nuggets of positive information will be celebrated. Eventually, the market will want to see solid, widespread results and over the years we’ve seen many recovery stories fail to live up to their initial promise.

ASOS arguably grew too fast, and the business wasn’t kitted out to cope with the success. Now we’re seeing office and warehouse closures, inventories reduced through slashing prices and plans for a cultural change across the company.

While investors have feasted on the latest update, it’s worth noting that earnings forecasts continue to be downgraded. Hope is currently driving the share price higher, not fundamentals, and that can only last so long. After all, longer term it is earnings progression that powers a share price.

It’s often better to wait for more evidence that a recovery is working rather than a single quarter’s trading results. Yes, there is a risk you might miss out on the initial part of a share price rally, but by waiting you would base your investment decision on more concrete evidence rather than hope.

Card Factory (CARD) is a good example. The greetings card retailer has been talking about a turnaround for some time, but earnings estimates didn’t start to be upgraded by analysts until October 2022. Between the start of last year and that earnings upgrade point, the share price had moved up and down in a small range but not broken out of the trend.

That changed in October when the earnings upgrades were triggered by evidence of a sustained improvement in the business. Since then, Card Factory’s share price has more than doubled thanks to a succession of upgrades to earnings forecasts.

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