Corporate Insiders are Turning Neutral on the U.S. Stock Market

As we enter a New Year, it is a good idea to review our stock selections and risk exposures.  It is well known that legal insider trading by top level corporate executives in their own firms can help provide useful investment signals (Seyhun 2000, Investment Intelligence from Insider Trading, MIT Press.)  Sustained insider buying in their own firms indicates a bullish signal while sustained insider selling indicates a bearish signal.  Insider trading patterns provide useful signals not only for individual stocks, but also for industry sectors as well as the aggregate stock market.

The historical average value of the insider buying index is around 34.  Above this level, I consider insider activity to be bullish.  Below this level, I consider insider activity to be bearish.  Insider trading patterns over the past six months indicate that insiders have regarded the European sovereign debt crisis and its potential impact on the U.S. market to be temporary.  As the stock prices took a dive during July and August of 2011, insiders have regarded the depressed levels of stock prices as a good buying opportunity.  Consequently, at a reading of 56 in August 2011, insider sentiment reached its highest level in over two years.  To find the previous high, one has to go back to March of 2009 when stock prices had reached a trough and insider buying rocketed to twice the usual levels. Index levels of 60 and above on insider sentiment around March of 2009 appeared to be extremely timely as Dow Jones Industrial Index has increased more than 80% since then. 

Since August 2011, however, insiders are gradually becoming less bullish.  While there is no evidence so far that they are worried about 2012, there are simply not increasing their stock market exposure.  As of December 2011, six-month insider signal is only slightly bullish, while a one-month insider signal at 33 is just neutral.

Looking at various market segments, insiders are still slightly bullish in small stocks, defined as those firms with a maximum market cap of $500 million.  In mid-cap and large cap stocks, insiders are again neutral to bearish.  It is also interesting to note that the small-cap Russell 2000 index has been lagging the larger cap stocks so far this year.  While Russell 2000 index is still down more than 4% for 2011 year to date, both Dow Jones and S&P 500 indices have moved into positive territory.  Based on this evidence, insiders expect the Russell 2000 to catch up to its  larger cap counterparts.

Looking at industry segments, a few sectors do stand out.  Insiders are still somewhat bullish on health care stocks.  Insiders had been bullish on financials up to November, but that has leveled off in December.   Currently, insiders are neutral on financials.  Finally, telecom and utilities sectors are registering big drops in insider sentiment. 

To sum, insiders are still not worried about the European sovereign debt crisis.  As of December 2011, there is no evidence that insiders are putting on the brakes on their risk exposure.  There is some evidence, however, that they are simply taking their foot off the accelerator at this time. We will keep watching.