Is a Strategy that Follows Insiders Worth While?

Is a Strategy that Follows Insiders Worth While?

By Matt Blackman

Insiders have had their share of bad press lately. But hundreds of insiders file documents to legally buy and sell shares in their own companies on a daily basis. Can this information help you decide when to buy and sell?

On December 1, 1986, Ivan Boesky was featured on the front cover of Time Magazine. Normally, this would be considered an honor but the publicity was not something that warranted bragging rights. The magazine featured a headshot of Boesky wearing an expensive suit and broad smile with a caption that read “Investor ‘Ivan the Terrible’ Boesky, Wall Street Scam – Making Millions with Your Money.”

Inside Notoriety

He had been charged with unlawful insider trading. In a quote that was to become famous, Boesky said of his conduct, “I think “immoral” is probably the wrong word to use…I prefer the word “unethical”.” Federal authorities were less philosophical and called it “illegal.” The court agreed. He was sentenced to 22 months in jail and ordered to pay a $100 million fine.

His arrest marked the end of an era of sorts. Until that time authorities seemed to turn a blind eye to the practice of reaping huge rewards with information not available to the public. Marty Siegel and Michael Milken were other casualties in the government’s attack on those using privileged information for profit. No longer would the practice of using privileged corporate inside information before it was available to the rest of the market be tolerated.

Trading scandals also resulted in stiffer reporting requirements. For the next decade, insiders were required to file written reports of any sales or purchases of stock in companies in which they were an officer, director or owner of 10% or more of a class of shares in a corporation by the 10th day of the month after the transaction was made. This meant that stock sold on February 1 would not have to be reported until March 10th.  It was an improvement but a lot could happen in nearly a month and a half.

It took another string of scandals more than a decade later to further level the playing field. As a result of the Enron and WorldCom fiascos, Congress enacted the Sarbanes-Oxley Act (2002), which mandated, among other things, that insiders report stock sales and purchases within two business days down from a maximum 30 prior to the Act.  

A New Indicator is Born?

By closing the insider advantage gap, regulations also made insider activity a more useful as an indicator. As of May 2003, all transactions had to be filed online electronically and this data made immediately available to the public. A number of companies are now racing to build products for all levels of market players, from the large institutional to the small trader. Previously cost prohibitive for all but the deep-pocketed, it is now possible to obtain daily and soon intraday insider transaction reports on various companies for a reasonable cost.

Figure 1 – Graph of the annual insider sell/buy ratio in all sectors of the market over the last 14 years. A low ratio signifies high levels of insider buying, a high value, extreme levels of selling. Data provide by Thomson Financial.

Using data going back to 1990, the insider data research analysts at wholesale data provider Thomson Financial consider any sell/buy ratio reading below $10 to be “very bullish” and above $20 to be “very bearish.” In examining annual data and comparing it to the chart of the S&P500 (figure 2), years in which the ratio was low (high amounts of buying) would have been the best times to buy the index. This occurred in 1990, 1994 and to a lesser degree in 1998 during the bull market. Selling spikes were in 1991, 1995, 2000, 2001 and 2003. During the bull market however from 1990 to 1999, the first two sell signals would have been losers. The signal in 2000 however, when the market had topped would have been better although more insiders sold in 2001, after the market had already corrected nearly 30%.

It is interesting to note that traders who sold on the jump from a sell/buy ratio of $7.25 nearly 300% to $20.25 from 1990 to 1991, would have been punished. The index jumped 10% between year-end 1991 when the signal was generated and year-end 1992. The year 1991 was also the first year of a bull market.  

A similar situation occurred between 2002 and 2003 when the ratio jumped from $12.05 to $26.67, the highest annual reading since records were kept. It was also the first year of a bull market and based on the experience a decade earlier, selling based on this factor alone would not have been recommended.