The prelaod will be meaured on the SMALL dial on the dial face. It should make at least 1-2 full revolutions on the small dial (and consequently the big dial too). This will be .100-.200 prelaod. I think that .300 is about the limit on your dial guage isn't it? On MM dials, there are 10 full revolutions, but on Inch dial indicators, I think that you're only allowed 3, maybe 4. I think that you may have had too much preload, and the needle starts giong backwards to as to not damage the internal? (I don't really know the inner mechanics of the dial guage)
Anyway, once you have this 1-2 revolutions of 'prelaod', and the motor at TDC, then zero the gauge.
Rotate the crank backwards until the needle stops moving counterclockwise. You should see no more than about a complete revolution (on an inch indicator). Zero the gauge again.
Rotate the crank clockwise again to TDC. Take the reading on the gauge. If the reading is greater than .037, then rotate the forward (to retard the timing), if it's less, then rotate the pump back towards the motor.
If you're still getting the strange situation where the needle (on forward rotation to TDC) is going forwards, then backwards, I think that you're off a tooth on the timing (or more). It's possible that you're 180 degrees off with the injection pump. When you're at TDC, you should be able to see a notch cut into the back of the injection pump sprocket. If not, it means that you've locked the injection pump off 180 degrees when you set the timing belt. You'll have to correct this issue before you can time the car with the dial indicator.
This could explain your stange situtation where the needle goes back and forth before TDC. You see, the flat spot on the internal cam of the pump is at the #1 injection stroke. You may be on the #4.
Good luck, and let us know what you find out.