by Ethan Roberts | January 31, 2013 10:34 am
When a bull market begins to show signs of being overextended, as we are now witnessing, the average investor faces some tough decisions. Do you stay the course and hope there isn’t a large correction, sell your positions to lock in profits or hedge your portfolio with puts or short positions?
The problem is that overbought doesn’t always mean done, and an overbought rally can continue for weeks or even months. I cringe as I recall selling my tech stocks in November 1999, only to see them shoot much higher over the next three months.
Despite being vindicated when tech crashed in 2000, I always wondered how much more money I could have made if my timing was just a little bit better. Thirteen years later, I like to think my knowledge of technical analysis is more astute, but the market is often capable of head fakes, no matter how savvy we may consider ourselves.
Recently, as the market has exploded, the percentage of corporate insiders selling shares of their own stocks has increased, and the ratio of insider sales to buys has hit a plateau.
Last week insiders purchased $25.42 million of their stock, compared to $111.09 million in the preceding week. However, insiders sold $701.64 million of stock, compared to only $385.32 million in the week before. This week’s totals signify about a 28-to-1 sell/buy ratio, which is high by historical standards. You can see from the accompanying chart how the moving average of insider buying has been dropping.
Insiders often have precise knowledge of their stock’s valuation, but how good are they at timing the overall market? In other words, does a rash of insider selling indicate that the larger indexes, such as the Dow, S&P 500 or Nasdaq are about to come crashing down?
It could be argued that if enough insiders are selling stock, a large number of shares are set to decline, dragging the major averages down as well. On the other hand, insiders may simply be trying to lock in huge profits on their own stocks, and are not betting one way or the other on the general market’s direction.
Also, this week both the buy and sell numbers were heavily influenced by a large transaction by one single investor or company. Carl Icahn purchased $100 million of CVR Refining (NYSE:CVRR), and a secondary offering by Cobalt International Energy (NYSE:CIE) accounted for $423.76 million in sales. Without those two transactions, the sell/buy ratio would have dropped below 11.
I’ve noted before that insider buying is a far more reliable indicator of future stock price direction than insider selling. An insider may sell shares because they need money for a new house, a bigger boat, a fancy wedding or retirement. While an expected drop in the stock price could be a motive at times, it’s just one of many reasons for insiders to sale.
On the other hand, when insiders buy shares of their company stock, it’s generally for one reason only: With inside knowledge of their company’s prospects, they expect the stock price to rise soon.
When the sell/buy ratio gets large, it often indicates a forthcoming decline in the market. Therefore, we can say insiders as a whole are pretty good at predicting market tops. The problem, however, is that during a bull market, the declines are often brief and not likely to be huge percentage moves. They may last a few weeks and are usually followed by an advance above the previous peak when the insiders sold.
So, if you’re a short-term trader, this is useful information. But if you hold stock for longer periods of time, it’s not always helpful to sell simply because the insiders are selling. Take a look at the weekly chart of the S&P 500 over the last three years. You’ll notice that most of the declines have been modest and were immediately followed by sharp increases.
The last time the sell/buy ratio was as high as it is now was June 2011, when it was over 8x sales to buys. You can see the S&P 500 fell from about 1,350 to 1,100 over the following month. However, by April 2012, it had risen above the previous peak. Since then, the pullbacks have been of much shorter duration and intensity.
So, investors have to decide for themselves whether to heed the warning of the insiders or not. Is this time the next big crash or simply the pause that refreshes?
My advice to those who don’t like to trade very often is simple. Instead of panic selling, consider the following three strategies:
1) Write covered calls on your long positions. For every 100 shares you own, you can write one covered call. This puts instant cash into your account, and if your stock declines, you can buy back the covered call at a much lower price and then write another one at a different strike price or length of term. The loss of value from the stock price will be largely offset by the money you make on the covered call.
2) Buy a few puts as “insurance.” If your stock drops, say, from $50 to $42, you can offset that loss or even profit by buying some longer-term, out-of-the-money puts. The time to buy these puts is when your stock is very extended from its most recent base or when the technical indicators such as relative strength indicator or stochastic are overbought.
3) Cap your losses. Consider setting up a trailing stop loss or stop limit order that will automatically sell your stock when it falls a certain percentage level below the current price. You can choose the percentage according to your own comfort level.
These strategies are superior alternatives to shorting the market, which can be disastrous during an ongoing bull market rally.
So, let the insiders sell. I wouldn’t buy any stock that insiders have been dumping, but don’t let them scare you out of your already-held long positions. If they’re wrong, the market goes much higher and you profit. If they’re right, and you follow the strategies listed above, you’ll either profit or break even during the decline, and be back in the chips again on the next market advance.
As of this writing, Ethan Roberts didn’t own any securities mentioned here.
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