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Rising inside sales the gloomy cloud on stock horizon

Most stock market watchers have their own favourite indicator of when investors might be getting too bullish or too bearish -- that is, when the market might be either heading for a fall, or due for a bounce. Some look at momentum indicators or volatility readings, while others like to track investor sentiment surveys or the ratio of buy-to-sell orders.

None of these indicators is the holy grail (despite what their proponents might want you to think). They are just ways of testing the market wind to see if the weather is likely to change. Of course, just because one indicator says a storm is coming doesn't mean investors won't ignore it for months or even years, as many analysts have found to their chagrin.

If you're looking for clouds on the horizon -- and many people not only aren't looking, but would prefer to ignore them if and when they see them -- there is one benchmark that has been extremely gloomy for several months now, and that is the ratio of insider sales to purchases of stock . Traditionally, this indicator is seen as bearish if it is higher than 20 to 1, and in October it hit a more than 10-year high of 59 to 1.

Not only did it hit an extremely high level last month, but it has been high for the past several months. In fact, October was the sixth month in a row that it has been above 20 to 1, a bearish period longer than any since 2000.

What does this mean? It means that insiders -- officers, directors and other senior executives of companies -- have been selling their shares at an increasing rate, and buying relatively little. October showed the lowest level of buying by company insiders since July, 1995.

According to Thomson Financial, executives bought just $52-million (U.S.) worth of their companies' shares in the month, and sold $3.2-billion. October was the fifth month in a row that insider buying failed to get over the $100-million mark, let alone the five-year average of $173-million. Both the number of executives buying and the number of companies where insiders bought were at half their historical levels, Thomson said.

Ross Healy of Toronto's Strategic Analysis Corp. wrote recently that the average insider is "selling shares and cashing in his options like there is no tomorrow." What insiders see for next year "cannot be all sunlight and good cheer, because rarely in all of market history (as far as such records have been kept) have insiders kept up such a steady barrage of selling relative to their buying," he said. According to The New York Sun, Thomson Financial analyst Kevin Schwenger said that "you really have to worry because these are the worst figures we've ever seen."

Market Profile Theorems, a market research company, has an insider sentiment indicator that is based on the proportion of sales relative to the total number of market transactions. A bullish ratio is about 30 per cent and the average ratio is around 50 per cent, according to director of research Michael Painchaud. Right now, the ratio is closer to 80 per cent. Jonathan Moreland of InsiderInsight.com, meanwhile, told Dow Jones he thinks insider selling points out risks that could "upset this sweet spot that equities are now in."

There are other measures as well, such as the Vickers Weekly Insider Report, which tracks insider sales compared with insider buying at the 30 companies in the Dow Jones industrial average, and weights them based on the overall number of trades at a company, the percentage change in an insider's holdings as a result of the sale, and so on. The Vickers index -- in which a rating under 2.25 is bullish and over 2.25 is bearish -- is now about 6, the highest level it has seen since 1986.

Some market analysts don't believe that insider selling is as good an indicator of sentiment as it used to be, and the main reason they give is the explosion of stock options that took place over the past five years. Since more executives have options, this argument goes, more are likely to sell large numbers of them for "estate planning" and other purposes, and that can distort the predictive effects of insider sales.

For example, University of Michigan finance professor and insider trading expert H. Nejat Seyhun told The New York Times recently that comparing insider sales ratios after 1991 with those before 1991 is misleading, because of a change in securities law. Before 1991, insiders weren't allowed to exercise options and then immediately sell the stock -- they had to hold it for six months. Professor Seyhun also said insider selling is a better indicator of bearishness if it occurs when the market is falling than when it is rising.

Those caveats aside, however, the insider sentiment ratio is still a disturbing dose of gloom amid all the sunny forecasts about the market. Could it be wrong? Of course it could. But it could also be a sign that the optimism among investors at large doesn't match the optimism among corporate insiders, and that's something worth thinking about.

mingram@globeandmail.ca

© The Globe and Mail

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