Insider Sentiment: Extreme Selling!

One way to assess corporate valuations is to keep an eye on insider transactions, especially those that involve buying more shares. After all, there are a lot of reasons someone may sell their corporate stock but really only one reason behind buying it. To review, insider buying is generally a bullish sign that people who know most about the inner workings of the business feel the stock is undervalued. On the opposite side, insider selling — unless in the extreme range — is generally not a bearish sign due to the many reasons that could be driving it. Nevertheless, moderate insider sales activity should raise cause for closer examination.

All that being said, CNBC’s Fast Money broke a story  this week about extreme insider selling activity which could indicate a correction in store for the equity markets:

The latest report from Vickers Weekly Insider, a publication that makes investments based upon these transactions, shows that total insider sell transactions relative to purchases on the New York Stock Exchange are running at a ratio of more than four to one over the last eight weeks. The normal reading, because of options selling and other factors, is about 2 sales for every buy, according to Vickers.

So, we have extreme insider selling occurring in the last 8 weeks while at the same time the market has had a nice run. Here’s a chart of SPY, the SPDR S&P 500 ETF, over the last eight weeks. Hmmmm…

Could all this selling activity mean we are about to experience a correction or is it a result of a large amount of insiders needing to dip into some stock for cash? Some say insiders are usually early — early to sell and early to buy — so could the correction be months away? Regardless, this unusual selling activity should be taken as a cautionary sign.

There is one ETF that specifically invests based on insider activity. It also considers the activity of the other group of people who know a lot about specific companies, analysts. The ETF, called the Guggenheim Insider Sentiment ETF (NFO), invests based off insider buying data and recent analyst upgrades. This ETF was launched in 2006, has been categorized as a Mid Cap Blend ETF by Morningstar. It holds a 4 star rating. (Full disclosure, I developed and launched this ETF in my previous role as President of Guggenheim Fund Distributors, formerly known as Claymore Securities) As you can see from the chart below, this ETF has outperformed the largest Mid Cap Blend ETF, MDY, the SPDR Mid Cap S&P 400 ETF, by a considerable margin (a double!) going back to NFO’s inception in September of 2006.

Will this outperformance continue? It probably will as long as we continue to climb upward. However should a correction begin, the strong recent outperformance of NFO and extreme insider selling that has taken place could point toward tactically shorting NFO and going long MDY. This pair trade would allow investors to continue to allocate into the Mid Cap Blend space but perhaps provide a greater cushion should a correction be underway.

Clearly, insider sentiment is just one way in which to gauge the market and assess valuations. Although it is not an exact science, it appears to be a common sense data point when considering investment opportunities. Today, after four years of volatile markets, it is interesting to note the outperformance by the only publicly traded insider sentiment investment product, NFO. Perhaps it’s time to harness sentiment — one way or the other.