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In-the-know insiders are dumping stocks

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In-the-know insiders are dumping stocks

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Corporate insiders are more bearish than they have been in almost 25 years. That isn’t good news for the stock market, since these insiders — corporate officers and directors— know more about their companies’ prospects than the rest of us.

In fact, you may want to take their pessimism as a signal to ditch some of your stocks or shift into industries in which insiders aren’t heavily selling, such as energy, financials and basic industrials.

From China to the U.S. to the emerging markets, there is an unusually heavy amount of conflicting data this year. Where are the opportunities for investors? Joseph Tanious, of J.P. Morgan Funds Global Market Insights Strategy team, joins MoneyBeat. Photo: Getty Images.

Just be aware that this record bearishness isn’t evident from the insider indicator that gets widespread attention on Wall Street — the ratio of shares of company stock that insiders have recently sold versus the number they have bought.

According to the Vickers Weekly Insider Report, published by Argus Research, this sell-to-buy ratio, when applied to transactions over the previous eight weeks, is higher than average but no higher today than it was one year ago — when the S&P 500 SPX -0.28% was poised to produce an impressive double-digit gain.

And in late 2003, just as the 2002-07 bull market was gathering steam, the insiders’ sell-to-buy ratio rose to even higher levels than it is today.

But this measure is misleading, says Nejat Seyhun, a finance professor at the University of Michigan who has extensively studied insider behavior. That is because it uses a government definition of insiders that includes a group of investors whose past transactions, on average, have shown no correlation with subsequent market moves: those who own more than 5% of a company’s shares.

Though on rare occasions a large shareholder also will be an officer or director, in almost all cases it will be an institutional investor — such as a mutual fund or a hedge fund.

Because the transactions of these big shareholders often involve a far greater number of shares than those of the insiders who do show more insight — officers and directors — the raw sell-to-buy ratio is heavily dominated by insiders with the least forecasting ability.

For example, Seyhun found that far from being a laggard, the average stock sold by these largest shareholders actually outperformed the market by 0.7% over the subsequent 12 months.

For his calculation, Seyhun strips out the largest shareholders from the sell-to-buy ratio. Currently that adjusted figure shows a record level of insider bearishness. According to this measure, corporate officers and directors in recent weeks have sold an average of six shares of their company’s stock for every one that they bought. That is more than double the average adjusted ratio since 1990, which is when Seyhun’s data begin.

One year ago, Seyhun’s adjusted ratio was solidly in the bullish zone, he says. And in late 2003, the ratio was more bullish still.

The current message of the insider data “is as pessimistic as I’ve ever seen over the last 25 years,” he says.

What makes this development so ominous, he adds, is that, while no indicator is perfect, his research has shown that “the adjusted insider ratio does a better job predicting year-ahead returns than almost all of the better-known indicators that are popular on Wall Street.”

There have been two prior occasions when the adjusted insider ratio got almost as bearish as it is today — early 2007 and early 2011. The first came a half a year before the beginning of the worst bear market since the 1930s. While the market didn’t fall as much following the second of these two instances, the May-October decline in 2011 did satisfy — based on intraday levels of the S&P 500 index — the semiofficial definition of a bear market as a 20% drop.

Contrary to what many investors may think, insiders aren’t necessarily breaking the law when trading on material information unavailable to other investors. The courts generally have deemed an insider transaction to be illegal only if the insider was acting on information that his firm would itself have been required to disclose to the public — such as an imminent earnings report that is going to be much better or worse than expected or a takeover announcement.

“In the absence of such announcements, insiders are considered to be trading on legal information,” Seyhun says.

Given that there is a lot of gray area in the application of the insider-trading laws, insiders often sell well in advance of perceived trouble coming down the pike to avoid the appearance, and potential legal liability, of selling right before bad news hits the market. So even if the insiders are right this time, it doesn’t mean the market is set for an imminent decline.

This suggests there isn’t any need to immediately sell your stocks, even if you are inclined to follow the insiders’ lead. However, you might want to get ready to sell any of your current holdings if and when they reach the price targets you set when purchasing them and park the proceeds in cash rather than immediately reinvesting them in other stocks.

Among the stocks you should be looking to sell are those in industries whose officers and directors are selling particularly aggressively. These sectors, according to Seyhun, include capital goods, technology, consumer durables (such as automobiles, construction and appliances) and consumer nondurables (food and beverages, clothing and tobacco).

If you nevertheless insist on putting new money to work in the stock market, you might want to favor those sectors whose insiders aren’t especially pessimistic, including the aforementioned energy, industrials and financials. Exchange-traded funds that are benchmarked to these sectors include Vanguard Energy VDE -0.02% , with a 0.14% annual expense ratio, or $14 per $10,000 invested; the Industrial Select Sector SPDR XLI -0.39% , with a 0.16% fee; and iShares U.S. Financials IYF -0.36% , with a 0.45% fee.

There are a handful of stocks in these sectors that corporate officers and directors recently have been buying heavily, according to David Miller, a senior portfolio manager at the Catalyst Insider Buying Fund INSAX +0.41% , which uses insider activity to buy and sell stocks and charges a 1.50% annual fee. Since its inception in mid-2011, the fund has returned an annualized 21.6%, versus 17.7% for the S&P 500, including dividends.

Two stocks that Miller points to are industrial conglomerate General Electric GE +0.20% and Continental Resources CLR +2.63% , an oil-and-gas company.

In-the-know insiders are dumping stocks - Mark Hulbert - MarketWatch

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