Leading Indicators in Pinstripes

Corporate insiders are buying stocks. Should you?

If stock buys by corporate insiders are any indication, we are in the first leg of a bull market. This may sound counterintuitive given the market's abysmal performance in 2002. But insider trading expert Michael Painchaud says executives' and directors' recent buys and sells show the Dow Jones industrial average hit bottom July 24 and will rally for the next year.

Painchaud, 53, has been studying insider trades for 30 years at Market Profile Theorems (MPT), a Seattle stock analytics firm, and has developed metrics for analyzing the market, sectors, and individual stocks. Why heed him? Many big institutional investors spend $25,000 a year for his advice. Among his clients are Fidelity Investments, Federated Investors, and Fiduciary Trust. They value this information because corporate insiders know when business is picking up or declining long before Wall Street analysts or investors do. Painchaud uses the data to make forecasts on companies and aggregates it to analyze sectors and the entire stock market.

For the past eight years, Painchaud has been publishing weekly market forecasts in a faxed newsletter called the MPT Weekly Insider Alert. Over that period, he turned from bearish or neutral to bullish seven times--most recently on Aug. 2. For the six previous bullish calls, the Dow was up an average of 15% over the subsequent six-month period. The average six-month gain over the eight-year period is 6.8%. He made good bearish calls in February, 2000, and April, 2002, but admits "sell" signals are often less accurate because "insiders can be bearish for some period of time before the market rolls over."

To make market calls, Painchaud employs the Brooks Ratio, a measurement he named after MPT co-founder Russell Brooks. The ratio divides total insider sales at a company by total insider trades (purchases and sales). He then averages this ratio for 2,500 stocks. If the average Brooks Ratio is less than 40%, he says it's bullish; above 60% is bearish. Painchaud thinks the market bottomed because on Aug. 2, the Brooks Ratio hit a low of 33%, a big drop from 70% in April. Since there's a one-to-two-week lag between the insider trading and when it is publicly reported, the buying really became aggressive around July 24, when the Dow hit its low for the year at 7489. As of Sept. 20, the ratio is up to 55%--neutral territory--but once he issues a bull market call, Painchaud recommends investors continue to buy stocks until the ratio turns strongly bearish again.

To analyze specific stocks, he also considers the historical sell-to-buy ratio, comparing current insider buying to the stock's long-term average. It's important because some stocks have a history of heavy insider buying or selling that could mislead investors into thinking it's a bullish or bearish sign when, in fact, it's business as usual. Other factors in his analysis include the number of shares transacted and the number of trades involving options.

Currently, Painchaud's insider model is bullish on the tech sector. "We're recommending the stocks nobody wants to touch," he says. Among his picks: LSI Logic (LSI ), Motorola (MOT ), IBM (IBM ), and Sun Microsystems (SUNW ). Outside tech, picks include Revlon (REV ) in cosmetics; Fleetwood Enterprises (FLE ), a mobile-home manufacturer; and Chesapeake Energy (CHK ), a natural gas company.

One problem with using insider data on specific companies is that sometimes execs don't recognize their own problems--and continue to buy as their companies implode. Examples are McLeod Communications (MCLD ), Nextel Communications (NXTL ), and XO Communications (XOXO ). That's why insider info works better in the aggregate. After all, it's hard to believe thousands of execs are wrong.

By Lewis Braham

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