What insiders are telling us about stock drop

It’s hard to put a smiley face on the stock market’s recent correction, which has already caused the month of May to be the worst for equities since last August.

But there actually is a silver lining to the correction: It affords us an unparalleled opportunity to see what corporate insiders REALLY think about their companies’ prospects.

Are they so worried that they want to sell their shares into the decline, for example? Or are they confident enough in their companies’ abilities to recover that they are willing to hold onto their shares through the correction?

This is an important distinction, since researchers have found that one of the more bearish things that insiders can do is sell into a decline. Selling into a rally, in contrast, is relatively benign.

Perhaps not surprisingly, the insiders aren’t currently speaking with one voice. On balance, though, they appear to be more confident than worried.

Here are the data, courtesy of Vickers Weekly Insider Report, published by Argus Research. The particular indicator that they publish that is most helpful is a ratio of the number of shares that insiders have sold in the open market to the number that they have bought.

In the week prior to the bull-market high at the beginning of this month, this ratio stood at 5.64-to-1—meaning that insiders, on balance, were selling 5.64 shares for every one share than they bought.

May's correction affords an unparalleled opportunity to see what insiders really think is going to happen in the market, according to Mark Hulbert, who says it's pretty telling if they're selling amid declines.

In the most recent reporting week, in contrast, this ratio had dropped to 3.28-to-1. That’s an encouraging trend.

To be sure, with insiders still selling more than three shares for every one share that they are buying, the insider data do not paint an outright bullish picture.

But, as Jonathan Moreland, editor of Insider Insights, put it over this past weekend: To the extent we CAN derive a signal from insider behavior, it remains “slightly bullish… much to our continuing surprise.”

Moreland adds: “Don’t get us wrong. We are no perma-bulls looking for any positive to justify blithely assuming the continuing loose-money associated imbalances will all work themselves out without causing pain to equity valuations. We are on record stating the opposite…. It all comes down to the timing. And going into this week we remain fully invested… ‘Better nimble than dogmatic’ remains our mantra in this tricky market.”

By the way, it might look on the surface that the sell-to-buy ratio at the market’s top (5.64-to-1) was a screaming sell signal, since at that time insiders were selling nearly six shares for every one than they were buying. But it’s helpful to remember that insiders on average over the last four decades have sold way more than they have bought. This is a function of the number of shares that they have been granted as part of their compensation—which means that their acquisition of those shares never shows up in the sell-to-buy ratio. But their sales do.

In fact, the skewness of this ratio towards the sell side has become more pronounced in recent years, as insiders have been granted an increasingly large share of their compensation through equity grants—especially options. According to some researchers, in fact, prominently including Prof. Nejat Seyhun of the University of Michigan, who is one of academia’s leading experts on insider behavior, the “normal” level of the insider sell-to-buy ratio may now be as high as 6-to-1, which means that even at the market’s high the sell-to-buy ratio wasn’t necessarily screaming “sell.”

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.