How to Read the Insiders' Story

A quick glance suggests they are bearish, but closer analysis shows confidence in the markets' future

The conventional measures of corporate insiders' confidence in the stock market are awfully discouraging. In the past two months, executives and directors sold shares in their companies more than three times as often as they bought. Another ratio of selling to buying is even uglier: Insiders sold $19 of stock for every $1 they bought. Their actions seem to forecast no end to bear-market pain.

But take heart. Insiders are actually turning away from their punishingly bearish conduct of the past two years. The key is insider selling volume by itself, without comparison to buying statistics. The increasing use of stock options for executive compensation has distorted the insider buying numbers. When insiders use options to acquire their company shares, those transactions are not included in the buy data.

Sell volume has fallen dramatically this year, easing pressure on the market. Average monthly insider selling over the past six months was $3.3 billion, vs. the $5.9 billion rate in early 2000, when the market was at its high, according to Thomson Financial/Lancer Analytics. Also, the number of insider sell orders is down 45% in the past two months, compared with February and March, 2000.

If the trend holds, it will clearly benefit stocks, helping the market at least to hold current levels. The decline in selling carries an important message for investors: Even though business has slowed, fewer people who are in the know think their stocks are too high.

When insiders dump shares, stockholders can't help but worry that they are missing some signs of coming trouble, says Eric Bjorgen, analyst at Leuthold/Weeden Research. Bjorgen, counting only big block transactions involving at least $1 million of stock or 100,000 shares, says the dollar value of net insider selling in the past 10 weeks is 0.8% of the value of the market, down from a peak of 1.8% in May, 2000. "I sure like what I see so far," he says.

Another measure, registrations for public sale of restricted stock, which includes shares held by venture capitalists, is down to a monthly average of $7.4 billion, from $16.2 billion a year ago. "That's a big decrease in the supply of stock," says Paul Elliott of Thomson Financial/First Call.

For decades, analysts have tried to divine the direction of stocks by examining insider trades. "Insiders certainly know more about a company than any analyst," says David Coleman, editor of Vickers Weekly Insider Report. Investors want to know what insiders do, not just what they say.

Traditionally, analysts gauge insider sentiment by watching ratios of selling to buying, whether comparing numbers of transactions, numbers of shares, or dollar values. Tracking buys has been considered critical. After all, insiders may have personal reasons to sell, but they only buy big blocks of stock if confident about the outlook.

Sell-buy ratios have been worthy indicators of past market moves. A ratio calculated by Vickers showed a big shift to insider selling in late 1986, before the 1987 market plunge, and then a shift toward buying in 1988. Another version, kept by Leuthold/Weeden, highlighted a market bottom in late 1990, and sent a clear sell signal in May, 2000.

But as insiders increasingly use options to acquire shares, counts of buys are understated, making sell-buy ratios less reliable. When executives exercise options, their actions are not added to tallies of buying--even if they continue to hold shares. Analysts haven't found good ways to measure the significance of exercises amid differences in option terms and taxes, says Elliott. Yet when executives sell shares obtained with options, the sells are counted. Analysts make adjustments, but they can really only guess how much more selling than buying is normal now.

Consider C.R. Palmer, chairman of driller Rowan Cos. (RDC ) and a veteran of 48 years in the oil business. In late June, Palmer exercised options on 122,000 shares of stock, two years before the options were set to expire. The purchase, with the stock 30% off its 52-week high, increased his holdings by 27%. Palmer says he's having to pay about $9 a share in income tax on the exercise. His move was a big bet by an industry veteran that his stock will be higher a year from now. Yet it wasn't counted among buys. No one knows how many more bullish decisions similar to Palmer's go unrecognized.

CAUTION. To be sure, the lack of clear evidence of insider buying is a nagging concern and is discouraging analysts from forecasting a new bull market. Buying in July fell to $78 million, the lowest amount since August, 1993. "It tells me they don't see the recovery as imminent," says Elliott. Says Lon Gerber, research director at Thomson Financial/Lancer Analytics: "There is a lot of caution. Nobody is making a commitment."

Energy execs are the exception. In July, insiders at Rowan, Baker Hughes (BHI ), Anadarko Petroleum (APC ), Apache (APA ), and Burlington Resources (BR ) made significant purchases. Energy execs tend to be savvy traders, says Gerber. At Anadarko, Executive Vice-President William D. Sullivan bought 10,000 shares in July for about $56, or $20 below the stock's 52-week high. The $560,000 purchase increased his holdings by 20%. Sullivan says he is taking advantage of Wall Street's underestimation of long-term demand for natural gas and overestimation of supply.

Ideally, executives will soon make more purchases like Sullivan's. That would give stocks a psychological lift. Meanwhile, considering how tough the market has been, investors can feel blessed that more insiders are holding tight to their stocks.

By David Henry in New York

    Before it's here, it's on the Bloomberg Terminal.