Interesting excerpt from John Mauldin
I was sent a copy of George Muzea's book called "The Vital Few or the Trivial Many," which is a study of how to invest with the insiders. George has been doing this for as long as anyone I know, and offers some insights in this really rather brief monograph. As compared with most books (mine especially!), you can read this book in a few hours and pick up a number of insights that will make you a better investor.
Muzea runs Muzea Insiders Consulting Services at www.smartinsider.net. It is designed for hedge funds and institutions and is priced as such, at $20,000 per year. Basically, he catalogs all the insider trading in listed stocks, ranks them and then rates the stocks according to the trading pattern. Some of the largest firms in the world use his service to try and give them an edge. (Contact info below, for those of my readers who run larger amounts of money.)
I was able to get into contact with him, and he graciously took me through his database. I made some notes and thought I would pass them along to you as to what insiders are doing today. He also allowed me to quote liberally from his book, so we can get an idea of how to get access to our own inside information.
It is useful to listen to George. He nailed the last bear market for his clients, as insiders were selling in masses in early 2000. He called the bottom of the recent bear, as again insiders delivered the signal. (He tracks movement in industry sectors and indexes, as well as individual stocks.) Interpreting insider trades is partially an art, as George has learned not all insider trading is meaningful. Sometimes, it can even be misleading.
First of all, this type of insider buying and selling is not necessarily illegal. If you are an officer or director of a company, you can buy and sell the shares of your stock. Before Enron, you simply had to file all your trades within a 30-45 day period. Now you have to file within two days. From these filings, one can now quickly discern what is going on in the "inside." Quoting George:
"The key word that you will read many times in this book is 'divergence.' Normal insider behavior would be to buy into price weakness and to sell into price strength. Just because they are corporate insiders does not necessarily mean they are savvy investors. A minority of insiders, mostly those with Wall Street roots, understand the investment community's response to news and are very conscious of the future trend of earnings and other important developments they expect to report. The majority of insiders, however, do not have a clue as to what causes their companies' stock prices to go up or down. This group is primarily focused on the inherent value of the stock relative to its current price.
"Regardless of whether corporate insiders are focused on news they expect to report or comparative values, all insiders understand the intrinsic value of their own companies' stock. Intrinsic value is the price at which a company could be liquidated or sold to an interested buyer. When their company's stock approaches or drops below intrinsic value, insiders buy. The lower it goes, the more they buy. One the other hand, when stock prices rise above their perception of intrinsic value, insiders sell. The higher it goes, the more they sell.
"Since it is normal for insiders to buy as their stock goes down and sell as it goes up, what we want to look for are divergences from this normal behavior. Your eyes should become wide open when you see an insider, especially the Chief Financial Officer who normally sells stock only when the price rises, suddenly break this pattern by selling into price weakness. It usually means that the company's business conditions have deteriorated and that bad news is coming. On the other hand, you should really be impressed when you see insiders buy at higher prices than their earlier purchases. This usually means business conditions are at least as strong as they were when these insiders first bought, and in many cases, getting stronger. Better than expected news usually surfaces a few months later."
George later summarizes his rules (quoting):
1. Insiders normally buy into price weakness and sell into price strength; therefore it is important to look for deviations from this behavior.
2. Stocks that have insider selling (three or more insiders) into price weakness should be considered seriously as candidates to sell.
3. Insider trading by operating officers is more predictive than those of other insiders, especially outside directors.
4. When analyzing insider trading, it is important to observe previous trading patterns to see if the current trade is in line with or a divergence from normal behavior.
5 .When insiders buy stocks that are depressed in price and out of favor, much of the time the buying is a sign of value, but sometimes it is simply designed to ignite investor confidence. The best way to determine which is which is to review carefully the dollar value of the purchases. If the insiders had sold previously at higher levels, they should be buying back at least 25 percent of what they sold; otherwise, they could be window dressing.
6. Most of the time one should look for clusters of insider buyers who have all made decisions to buy stock in their companies. However, sometimes a single trade can be predictive, especially when the buying insider has a good trading history in that stock or the purchase is an unusual divergence from past behavior.
The book is a paperback and is just $13.57 from Amazon. There is an older version so make sure you get the just released one. It is a collection of wisdom and great stories from a market veteran and a wonderful story-teller. You can find it at www.amazon.com.
So what is George telling his clients today?
First, in his January 11 letter he still has sell signals on the S&P 500, S&P 400 (mid-cap), S&P 600 (small cap) and the Russell 2000, based on patterns of insider selling from December
He presciently wrote: "Last week, the media was scrambling to come up with reasons for the decline. Discussions ranged from profit taking in last year's winners to back-to-back weeks of $1.1 billion in cash outflows from stock mutual funds. It might be useful at this time to avoid headlines and government statistics and look at the market itself for clues as to how serious to take the current decline.
"In last month's review, we reported that insider selling increased dramatically in December, reaching previous top levels. At the same time that insider selling reached top levels, Investor's Intelligence Advisory Sentiment bulls was 62.9%, the highest level since January 1987 and the American Association of Individual Investors (AAII) weekly poll had 60% bulls and only 18% bears."
When you read his book, you find out that when there is a divergence between insider selling and public opinion (thus the Vital Few vs. the Trivial Many) it is an indication of major and intermediate tops and bottoms. What we are still seeing today is a very bullish public and insider selling - not a good sign. He goes on:
"In our opinion, whether or not the current decline escalates into something more sinister depends on the actions of insiders and stock mutual fund investors. The peak of redemptions and forced liquidations of stocks by equity fund managers always occurs at or near market bottoms. For example, the short- term bottom of September 2001 had net outflows of $29 billion. The actual bottom for most stocks occurred in July 2002, which had $53 billion in outflows. In both cases, insiders bought into these redemptions.
"Current outflows are modest but whether or not they cascade into double-digit outflows depends largely on the mood of the public, heavily influenced by the actions of the market and the sentiment of market letter writers that influence them. Last week's AAII poll showed bulls dropped to 38% and bears increased to 35%, a sign that last week's decline frightened individual investors. Low risk entry points occur when insiders are bullish and investment sentiment is extremely bearish into a deeply oversold market fueled by forced equity fund liquidations, often accompanied by a negative news story. None of these ingredients are in place now, and we expect it will take a much more serious decline to get what we want.
"Most short-term technical indicators are now oversold; therefore, a rally could occur at any time [and we saw one this last week, which lasted all of two days - JM]. However, long-term indicators are still overbought. For example, the percentage of stocks in up trends in our four major indexes is 70% and most market bottoms occur below 30%. With insiders still negative, we believe there is a high probability that short-term rallies will fail and the next low risk entry point for long-term investors will occur later this year. We continue to recommend portfolio managers be focused and selective in buying.
"CONCLUSION: Current insider trading patterns suggest that overall market risk remains high. We will monitor short-term rallies carefully to see if insiders sell into them. We will also monitor stock mutual funds cash flows."
But it is not all doom and gloom. There are places where there is quite a bit of insider optimism. One of those is energy, where Muzea has a sector buy based on insider buying. Looking through the group, the buying seems to be focused in various smaller oil and gas plays.
Looking at other sectors, there is strong insider buying in certain smaller regional banks.
So how does the little guy play the insider game? Muzea points out several ways. You look for companies that are making new lows, go to finance.yahoo.com and type in the company symbol. On the right hand column there are several listings of insider trading. If a company is down, but the insiders are buying, it is time to start your fundamental research to see if this looks like a turnaround. It is contrarian investing, and tough to do, but with a hint from the insiders that something is afoot it can be your most successful investing.
Before you buy any stock, you should perform that simple task. It is free and quick and may be worth more than all the research reports you read. Not to put too fine a point (or sales job) on the book, but if you are a stock buyer, you should pony up the $13 and buy the book to get the wisdom of a guy who has been looking at insider trading longer than most of us have been investing.
For those institutions interested in George's services mentioned above, you can contact him at his email address at gmuzea@charter.net. He will offer a free trial if you mention my name.
It's Starting to Look Ugly
To follow up on Muzea's market call, let's look at a few other thoughts. Those clever folks at The Leuthold Group noted on Wednesday that we are about to get a record January. Typically, mutual fund inflows are positive in January. Last year we saw $28 billion flowing into mutual funds. So far this month, we have seen a net estimated outflow of $9 billion. Since the markets are well off the last two days, it is likely that number is worse.
They note: "Record January On Tap? In recent years, it has become relatively rare to use the term 'net redemptions' and 'January' in the same sentence. Net outflow did occur in January 2003, but was a relatively small -$1.3 billion. But this year, January is not only shaping up to be a month of net redemptions, but record net redemptions. Unless the final three days show very strong positive cash flow (we'll have a better idea if this is the case in next week's report) it is likely that we'll be reporting a new cash flow record for January. But just not the kind of 'record' we have come to expect."
My friend and the very smart Richard Russell notes today: "Here's what I think we're seeing. The market established oversold lows on January 24 (I keep talking about those January 24 lows). Next we have the bounce off those lows, which we can call an upward correction. The longer and higher the move off the January 24 lows, the more important those January 24 lows become.
"Somewhere ahead the market will turn down to test those lows. That will be a very important test. If one or both Averages (Industrials and Transports) hold above the Jan. 24 lows, that will be an important and constructive test for the market. However, if the two Averages, BOTH of THEM, break below their January 24 lows, particularly on heavy volume, we're in for trouble, important trouble.
"To refresh your memory, the January 24 lows were Industrials 10368.61. Transports 3454.78. Mark 'em down, and keep 'em in mind."
The Dow is one bad session from those lows. The Leuthold Report noted that large cap mutual funds saw positive inflows. If there is investor concern over the weekend in that arena, we cold see those stocks drop as well.
Of course, there has been a lot of selling by traders prior to this weekend's election in Iraq. If they come off modestly well, they could be back in with force.
My thoughts? I think we drift down from here with a last gasp rally later in the early spring, then into an ugly summer, much as last year, with a late year rally after tax loss selling by institutions (mostly mutual funds), which must sell by October 31st, if they are to balance their gains. Will the rally recover to new highs? It did last year, but I think the economy will be seen as weaker in the winter of 2005. Thus I expect the market to be lower at the end of the year. We do not see the resumption of a real bear market until a recession is peering around the corner at us.
We saw the economy drop to a 3.1% GDP last quarter. That is down sharply from 4% the previous quarter, and some of the growth was from inventory build-up. It is like the old children's campfire scare story: "Slowly he turned. Inch by inch, step by step, until...." |
