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Insider trading often refers to acting on material nonpublic information. However, when company employees buy and sell their own stocks, it is also called insider trading, which is permitted by the SEC. We will only discuss the second type of insider trading today. As many investors have wondered, is it a fair game for outsiders when insiders are allowed to trade their own stocks freely? A significant amount of research has focused on the profitability of insider trading. Following the same methodology, we will examine from the holistic stock market perspective.
Insiders usually refer to corporate officers, directors, and large shareholders. Intuitively, these roles possess an informational advantage over outside investors. For example, the CEO of XYZ Co. must know more about XYZ than my retired mother-in-law who enjoys her beach life every day in FL; however, the CEO can trade the XYZ stock almost as easily as my mother-in-law in the open market. In fact, some recent academic research has found that insiders execute short-swing trades that beat the market by approximately 15 basis points per day, and systematically divest ahead of disappointing earnings announcements (White, 2020). In addition, the options market experiences positive abnormal volumes with bullish directional trading before 25% of the overall takeover announcements; yet, SEC only litigates about 8% of all deals (Augustin, Brenner, and Subrahmanyam, 2019).
In the U.S. equity market, a popular insider trading gauge is the Insider Buy/Sell ratio, which is the aggregate insider purchase over insider sale. Normally, the ratio stays between 0.4 and 0.5, indicating roughly twice as much insider sale volume as purchase. This is understandable given that many insiders receive stock compensations. There have been only 11 months when the ratio reaches above 1 since 2004, meaning there are more insiders buying than selling their stocks. Interestingly, each insider purchase spike coincides with a market drop. While the highest reading on the ratio came from the financial crisis in November 2008, the second highest reading was just March this year—both can be viewed as the entry signal of the decade. (See Chart 1 below)
Digging further into the insider buying frenzies, we find that the stock market post-performance once Insider Buy/Sell ratio jumps above 1 is phenomenal. As Table 1 demonstrates, the U.S. equity market increases about 25% in 1 year and 54% in 3 years. Next time someone doesn’t believe in market timing, maybe we should point them to the corporate insiders.
Market efficiency hypothesis argues in the strong form of market efficiency, insiders do not possess informational advantage over the market. Unfortunately, we live in the semi-strong form market efficiency at best, if not the weak form. Therefore, from the market efficiency perspective, it is not a question whether insiders know more than the outsiders, but how much do they know? At Cumberland, we constantly track these activities across all S&P 500 sectors to seek market signals. However, this commentary is not to recommend a “Follow the Leader” type of strategy to our readers, as past performance does not guarantee future returns.
(See Leo’s September 14, 2020 follow commentary here: https://www.cumber.com/cumberland-advisors-market-commentary-insider-trading-the-case-of-energy/)
*Data from Bloomberg as of August 20th, 2020.