A spate of insider buying has sparked hopes that we are seeing a correction in a long-running bull market, writes Proinsias O'Mahony
It is doubtful that Rudyard Kipling was thinking of beleaguered company directors when he defined a man as someone who can "can keep your head when all about you/ Are losing theirs and blaming it on you". Amid plunging share prices and growing concerns over the very stability of the global financial system, however, company insiders in the US and Britain have ignored the voices of doom and been busy buying shares in their own companies.
"Insider sentiment is very strong and it is being paced by the financial industry. Sentiment is not as strong as we saw during the August market meltdown, but it is historically high, or more bullish than normal," said Ben Silverman, director of research at InsiderScore.com, a US website that monitors insider trading data. Its latest report shows that buyers have now outnumbered sellers for six consecutive weeks.
Silverman's research is confirmed by numerous other followers of insider data. The Vickers Stock Research Group has been collecting and analysing insider statistics over the last 50 years. It maintains that insiders in the US typically sell shares between 2-2.50 times more often than they buy shares. As a result, when the various sell/buy rations exceed 2.50, it is regarded as a bearish indicator for the equity markets. Conversely, readings below 2.00 are seen as bullish.
The most recent Vickers Weekly Insider Report shows that the average insider sold just 1.26 shares for every one share that he bought - well below the historical average and indisputably in the bullish camp.
Indeed, insiders have been buying at a furious pace for some months now, with the brutal sell-off in August occasioning the largest monthly insider buying spree since 1990 (more than $465 million/ €317 million of stock was purchased, according to Thomson Financial).
Executives in financial companies have been the big spenders of late. High-ranking officials in Fannie Mae, the US mortgage giant, have been emptying their pockets over the last week, with purchases in excess of $1 million being made since the stock's butchering over the last month (after peaking at $68 in October, the stock fell to a low of $26 in November, chopping more than $35 billion off the company's market capitalisation).
Insiders at Wachovia, America's fourth largest bank, have also been busy, with a rash of buying from company directors. One director recently purchased almost $4 million worth of stock.
"Following the insiders" is one of the few investment strategies that has, over time, consistently beaten the market averages. A research paper by professors Josef Lakonishok and Inmoo Lee found that the periods marked by the heaviest insider buying were followed by average market returns of 29 per cent over the following 12 months, whereas returns dropped to just 9.7 per cent in periods characterised by heavy selling.
Prof Nejat Seyhun, author of Investment Intelligence from Insider Trading and one of the leading academic authorities on the subject, has estimated that stocks characterised by insider buying have tended to outperform the broader market by almost 9 per cent over the following 12 months and stocks marked by insider selling have, on average, under-performed the market by 5.4 per cent.
Prof Seyhun's research suggests it is normal for company insiders to take advantage of rising prices by unloading stock. A more worrying sign for the market as a whole is when insiders continue to dump stock in a declining market. The fact that insiders are using the recent market weakness to gobble up company shares suggests that we are seeing a correction in a long-running bull market rather than the start of a bear market.
In the UK, insiders have been similarly active. Khuram Chaudhry, chief European quantitative strategist at Merrill Lynch, says the increased buying by British directors "provides a technical buying signal". Research by Merrill dating back to 1986 has shown that when the ratio rises above 5:1 - that is, when there are five buys for every sell in the market - market returns over the following one-, three- and 12-month periods have been positive. The ratio has moved up from 4:1 to 7:1 over the last four weeks, "below the ratio of 10:1 seen in August of this year, but nevertheless suggesting a near-term opportunity", Chaudhry said.
"Company directors are signalling that their stocks have fallen sharply in a small time period and may well be discounting too much negative momentum in the short term.
"However, economic and profit expectations are slowing and a rally may prove short-lived."
Chaudhry's assessment of those economic realities mean that he is cautious, despite insider optimism. "Given that the global economic cycle is slowing and profits revisions are being downgraded, we are reluctant to believe any bounce on the back of depressed sentiment is likely to lead to a rising stock market on a 12-month view," he cautioned.
His words are echoed by Silverman of InsiderScore.com. "The recent market volatility, the obvious headwinds facing the US economy and the continued disruptions in the mortgage, loan and credit markets mean that I am cautious, despite the sentiment reading," he said.
Insiders who bought after the August correction have suffered some serious pain since, with the Philadelphia Banking Index falling 20 per cent from its August peak to its November low.
"There are quite a few examples of insiders being caught on the wrong side of the tape after buying in August because they failed not just to predict the near-term performance of the market and their stocks, but the actual performance of their businesses," Silverman said.
