Why You Need to Follow the Insiders
In February 2020, most retail investors didn’t know what was happening with COVID-19.
Many politicians told Americans to continue going out to restaurants.
They said that they shouldn’t avoid public events. But they failed to disclose the threats they heard behind closed doors in Washington. Some leading politicians even dumped large amounts of stock, knowing that COVID-19 could ravage the U.S. economy.
If only there was a significant indicator that similar selling was happening at the executive levels of many public companies.
Oh, wait. There is one.
It’s called “insider buying and selling.”
And it is one of the most important signals that you can use if you’re worried about a potential market crash.
Follow the Insiders
Last year, COVID-19 caused significant disruption to the global economy and the stock market. We witnessed the fastest bear market in history. It was followed by the quickest bull market in history. The stock market was fast and furious.
We know about the Federal Reserve’s unprecedented actions to unleash a wave of capital onto the economy. And we know that when the uncertainty started, there were some ambitious moves by corporate insiders to sell their stock.
When I say “insider buying and selling,” I’m not talking about the illegal practice of using private information to trade a stock. That’s “insider trading,” which refers to the use of nonpublic information to trade a stock before a major catalyst hits.
Insider buying refers to the practice of corporate executives buying their company stock with their own money. Insider selling refers to the sale of those same assets by those executives. Insiders can refer to positions like the chief executive officer (CEO), chief financial officer (CFO), the chairman of the board, members of the board of directors, and anyone who owns more than 10% of the stock (and likely has a board seat).
The reason why investors should follow the buying and selling practices of these members is pretty obvious. No one knows the balance sheet better than these executives, who can act on information related to their business that might affect the stock price in the future.
What Happened in 2020
Recently, researchers at Simon Fraser University and the Ross School of Business (at the University of Michigan) conducted a study of insider transactions that occurred during the first few months of the COVID-19 pandemic.
They studied more than 300,000 insider trades. And the results were pretty incredible. The researchers started with a pretty basic thesis.
If an insider believed that COVID-19 would impact the company’s future outcomes and thus the stock price, they were more likely to sell the stock.
Inversely, if the insider believed that positive catalysts existed for the future, they were more likely to buy the stock. The study examined buying and selling activity across the United States, China, Canada, Italy, Spain, and South Korea.
Key Findings from the Study
There are a few key data points from the study that stood out:
- The researchers discovered a significant amount of insider selling in January and early February among investors with Chinese backgrounds. This insider selling coincided with a period when COVID-19 cases were rising in mainland China but had not yet hit the United States.
- U.S. insiders engaged in a lot of selling in late February. These transactions, which investors can track through Form 4 insider designations with the SEC, were part of a longer-term trend of selling. However, this was short-lived. Insider selling quickly turned to insider buying in mid-March.
- In March 2020, as the S&P 500 fell nearly 35%, insider buying hit record levels. The buying transpired at larger firms that had significant book value or higher levels of debt and leverage. The strongest buying during that period came in the financial, energy, and consumer sectors.
- In April 2020, insiders increased their stock buying despite the sharp appreciation in the market from the March bottom.
What 2020 Insider Buying and Selling Tells Us
The insider buying that happened in March 2020 coincided with the Federal Reserve’s decision to unleash a wave of capital across the markets. If you recall, Minneapolis Federal Reserve Bank President Neel Kashkari appeared on “60 Minutes” and said that the central bank would provide support across the entire economy.
Not everyone believed the Fed would take such action. But executives at companies did. The fact that so many firms that had significant debt saw insider buying is a testament to the expectation that the Fed would provide cheap cash to support business.
Sure enough, it came. But the record amounts of buying also signaled another important element. In this time of great uncertainty, insider buying continued, and these investors continued to expect that share prices would rise in the future. It’s another reminder that insider buying and selling is a very predictive metric for future returns. There is plenty of academic data to support this indicator, which I’ll cover more in the weeks ahead.