The Insiders Aren’t So Bearish, After All

Strategies
The Insiders Aren’t So Bearish, After All

http://www.nytimes.com/2007/08/12/business/yourmoney/12stra.html?ex=1344571200&en=c758faede7392d58&ei=5088&partner=rssnyt&emc=rss

August 12, 2007
By MARK HULBERT

THE sharp stock market decline that began in late July is more likely to be a minor downturn in a continuing bull market than the beginning of a major bear market. That, at least, is the conclusion of an extensive analysis of corporate insiders’ trading behavior.

Insiders are a corporation’s officers, directors and largest shareholders. It stands to reason that they know more about their companies’ prospects than the rest of us do, and many investors pay close attention to whether that group is buying more than it is selling, or vice versa. Insiders are required to report purchases or sales of shares of their companies’ stock immediately to the Securities and Exchange Commission.

On the surface, it is hard to conclude that insiders are behaving bullishly. For the year to date, corporate insiders, on balance, have sold more than 15 shares of their companies’ stock for every one they have bought, according to Argus Research. That certainly looks bearish.

But that reasoning is based on a serious misinterpretation of the data, says H. Nejat Seyhun, a professor of finance and business administration at the University of Michigan who has devoted much of his academic career to analyzing insider behavior. When properly interpreted, he argues, insider behavior this year is bullish — more bullish, in fact, than it was in 2006.

How can Professor Seyhun reach such a conclusion? Perhaps the biggest factor is the role played by stock options that companies often grant to insiders. When insiders exercise the options and then sell the shares they receive, typically only the sales will show up in the ratio of marketwide insider sales to purchases. That’s because that ratio focuses on transactions made in the open market at then-current prices. Buying a stock through the exercise of an option doesn’t qualify, because the purchase is made at the strike price of the option, not the prevailing price on the open market.

There is nothing new in the way insider transactions are summarized; it has been done this way for decades. What is new is the explosion in companies’ use of options to compensate top executives. As a result, insider selling is of far less bearish significance than it was several decades ago.

For historical comparability, Professor Seyhun argues, insider sales need to be weighed according to whether they occur immediately after the exercise of an option.

In unpublished research, he has done just that. And he has taken into account other factors he has found to be important in interpreting insider behavior. These include the type of insider who made the transaction, the size of the transaction, and whether it occurred in the context of a rising or falling stock price. A good summary of that previous research is in his book, “Investment Intelligence From Insider Trading” (M.I.T. Press).

The research has resulted in what Professor Seyhun calls his Insider Confidence index. He calculates it by dividing insider purchases in a given month by insider sales, after adjusting both halves of the ratio by the various weighting factors. He has compiled this index back to the mid-1970s, and found it to have an impressive record in predicting the market’s subsequent 12-month return. Based on that history, he said in an interview, he considers readings below 45 percent to be bearish, and levels above 55 “strongly bullish.”

Where does the index stand now? For the first seven months of 2007, it averaged 56.7 percent, he said, and at the end of July it stood at 57.4 percent. These readings are well above the bearish zone, and slightly inside the “strongly bullish” zone. They are even a bit above the index’s average 2006 level: 55.9 percent.

One reason that the index is a good forecasting tool for the market’s direction for up to a full year, he added, is insiders’ fear of being accused of trading illegally on privileged information. Insiders therefore have an incentive to make long-term rather than short-term bets on their companies.

Assuming that insiders live up to their historical patterns, they will give us ample advance warning before the next major bear market. So far, they haven’t sent such a signal.

I believe that this indicator will turn out to be wrong.  With liquidity as plentiful as it was just a few weeks ago, executives were very optimistic in general.  I am quite certain that this optimism will  turn into pessimism in the next few weeks.

Edited 1 time(s). Last edit at 08/11/2007 09:51PM by regli.

Here we have some solid evidence that executive sentiment has changed dramatically: