Nejat Seyhun's Take on the Flood of Insider Sales
It should be pointed out that insiders have been heavy sellers of stocks for quite some time. Insiders are almost always early, both in their buying and selling. This is no surprise, as by the very nature of the situation, they have an informational advantage and are bound by legal constraints, which expresses itself inter alia as an often considerable lead time in their activities. If one tries to time one's investments by relying solely on insider data, one will often find one's patience taxed, since what is needed for the investment to produce a positive return is usually that other market participants begin to recognize what the insiders have known all along.
So what is the current situation? As noted at the beginning, insider selling hasn't just picked up recently – it has been quite heavy for a long time now. What makes the current situation remarkable is only that insiders haven't expressed this much skepticism about valuations for some 25 years, as Mark Hulbert reports. He has some interesting information on how the data on insider activity need to be parsed to arrive at actionable intelligence:
“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. Just be aware that this record bearishness isn’t evident from many of the insider indicators that get widespread attention on Wall Street—those based on a ratio of insiders who are selling to those who are buying.
According to the Vickers Weekly Insider Report, published by Argus Research, which calculates a proprietary version of this sell-to-buy ratio, insider selling over the last eight weeks, relative to insider buying, is higher than average, but no higher today than it was one year ago—when the S&P 500 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 insider sell-to-buy ratios can be misleading, says Nejat Seyhun, a finance professor at the University of Michigan who has extensively studied insider behavior. That is because the government’s definition of insiders includes a group of investors whose past transactions, on average, have shown no correlation with subsequent market moves: those who own more than 10% of a company’s shares.
Though on rare occasions such 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. These entities are outsiders in all but name, and they have 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.
We weren't aware of this "large shareholder effect", but it certainly makes sense the way it is explained here. Whenever one looks at insider activity in individual issues, one does after all focus on what directors are doing as well. An exception to the "large shareholder rule" is investment or divestment by a bigger company in the same line of business, which presumably must be regarded as meaningful as well. The fact that traditional insider data services fail to make the differentiation proposed by Mr. Seyhun may be one of the reasons why so far, phases of heavy insider selling have not meant as much as one might expect. However, as the report above indicates, things have now changed rather dramatically. Insiders could of course still be early. They are not necessarily stock price forecasters – they only have information about the performance of the underlying business (obviously, stock prices and business performance can frequently be different cups of tea for extended periods of time).
Moreover, insiders are constrained when material information (such as a big earnings miss, news on the regulatory front, etc.) is about to be disclosed. So it is usually a judgment call about valuation and often probably a hunch that either trouble or better times for the business are in the offing further down the road. A CEO or CFO might e.g. see some trends in the numbers the meaning of which he can judge from experience, but which do not rise to the "material information" standard that bans trading activity prior to public disclosure.
According to Mr. Seyhun's methodology, the following sectors are currently experiencing the most determined and aggressive selling by company directors: capital goods, technology, consumer durables (i.e., automobiles, construction and appliances) and consumer non-durables (food and beverages, clothing and tobacco). As we have pointed out, we see the recent weakness in technology stocks as a warning sign, and the above observations about insider activity lend support to this hunch.
Our guess would be that corporate officers are mainly concerned about valuations at this stage, but one cannot rule out that they are aware of a subtle deterioration in business that will only become obvious to other market participants at a later stage.
The NDX has reached a new high for the move in early March, but since then is looking a tad wobbly. The past two trading days have seen sharp declines on heavy volume.
XLY, the consumer discretionary ETF. This one has not diverged from the broader market, but it suffers from internal divergences – for instance, the stocks of car makers have failed to confirm the recent move to new highs in XLY.
XRT, the retailer ETF. Note that it has now diverged from the SPX twice in a row.
A More Hostile Fed
Monetary expansion and its lagged effects remain supportive factors for the market, but even there we see a reversal in trend and a far more hostile Fed.
Note in this context that every time a new Fed chairman/chairperson has taken over since Volcker in the late 1970s, monetary tightening was on the agenda. We suspect that most Fed chairmen are trying to bow out on a "high note", this is to say, with money easy and the stock market elevated. By contrast, new chairmen are usually under pressure to prove that they are in agreement with the official "inflation fighting" (ha!) orthodoxy of the central bank, and finding monetary conditions loose, begin to tighten in the early part of their stint as Fed chief.
It happened this way with Volcker, Greenspan and Bernanke, and only Volcker managed to dodge a stock market crash (although the "double dip" recession in the early 80s was not a fun time for the stock market either). Ms. Yellen arrives on the scene with the market one of the historically most overvalued in history, a veritable mania in junk debt that absolutely dwarfs anything that has been seen before in this asset class and with monetary policy the loosest of the entire post WW2 era. So our guess is, she isn't going to be able to dodge a crash either, the main question is when it will happen.
The list of signs suggesting caution is getting longer by the day. Caveat emptor, as they say.
Charts by: StockCharts