Insiders Send a Signal

John Mauldin | Thoughts from the Frontline
January 28, 2005

Is the US stock market rolling over? What are insider investors telling us? Are there sectors that might run counter to the overall trend? We look at a variety of topics this week, I point some of my hedge fund and institutional managers to an excellent source for information on insider investing and point the rests of my readers to a new book which shows you how to separate the "Vital Few from the Trivial Many." All in all, it should be an informative letter.

But before we delve into the arcane matters of the market, I want to direct your attention to a hot-off-the-press new book by Peter Bernstein entitled "Wedding of the Waters." Peter is the author of the best-selling (and one of my all time favorite books) "Against the Gods: the Amazing Story of Risk" and the fascinating and well-told tale of "The Power of Gold: History of an Obsession." Whenever Peter writes anything, it will be worth your time. His economic advice and research is some of the most keen and insightful anywhere, as attested by his numerous awards and well-deserved honors. But his knowledge of history and the ability to tell a story puts him into league of his own among financial writers. (He and Richard Russell are my heroes. Both are in their early 80's and doing their best work. I hope to be going as strong as they do in 25 years.)

"Wedding of the Waters" is sub-titled: "The Erie Canal and the Making of a Great Nation." It details the building of the Erie Canal in the early 19th century which connected the Great Lakes (Lake Erie) and Buffalo to Albany and the Hudson River, which led to New York and the rest of the world.

This opened up the Mid-West to cheap and easy transport of their products and allowed people to travel to new homes in the Mid-West. Now, I know many of you are thinking, "Why do I care about a big ditch built almost 200 years ago destined to become a big polluted ditch later in the next century?"

First, it is fascinating history. Second, if you don't know history, how will you know when it is getting ready to at least rhyme, if not repeat? Every new technological innovation has a set of events that happen on its way to becoming the catalyst for a new economic boom. It is the new advances and wealth that spring from the primary innovation that become the enabler of ever new ways for entrepreneurs to thrive in a free market.

The Erie Canal is really three stories. First, it is a testimony to the vision and drive of a small group of men, primarily DeWitt Clinton, who by force of will caused the Canal project to come into fruition. Secondly, it was an engineering marvel that required whole new technologies and systems, many of which were not invented when the project started. They had to build monster aqueducts over huge chasms, an entirely new lock system, to get past the Niagara cliffs, and went through such desolate country that to "fly over it would make an owl weep." That it was finished was amazing.

Finally, it was the catalyst for an economic boom that turned the US into an agricultural and manufacturing power and cemented the US into a country. It is the latter point I will deal with for a few moments.

I read this book as I was researching last week's article on China. As I was contemplating the question of whether (and when) China would become as large an economy as the US, I also reflected upon why the US became larger than England. Were there any parallels?

England in the 1800's was at the peak of her world power. She was an economic force and mercantile power. Gold was flowing into its coffers from the far corners of the world. Who could predict that one day the US would be a far larger economic power? England was the birth place of the steam engine, railroads, canals, ironworks, cloth mills and on and on. What happened? I think freedom and an entrepreneurial spirit is what happened.

In 1815, England passed the Corn Laws, putting high tariffs onto imported food, especially grains to protect their aristocratic farmers. This made the cost of food for a laborer the majority of his wages, and left him nothing to spend on other products. It slowed the development of the middle class. Grain in Europe and in the US was much cheaper, and the aristocracy which had always lived off the value of their lands did not want to see their profits lessen, so they kept the prices artificially high, which limited English growth. It took 30 years to repeal, and only after suffering through a famine in all of Europe and especially Ireland which saw millions of Irish lose their lives, and other millions come to the US, where their backs helped us grow.

While England was protecting the ruling class, politicians in the US were dreaming bold dreams. None was more audacious than that of DeWitt Clinton, Governor of New York, who correctly foresaw that a canal connecting the Great Lakes and ultimately New York City would be a catalyst for economic enterprise plus cement together the west with the eastern United States. Without commerce, both Clinton and George Washington observed (and the mountains were a formidable barrier), what would hold the loyalties to the East of those going over the mountains to the West?

Washington favored a private company building a canal from the Potomac through the Virginia mountains, and raised the money for the enterprise. Clinton wanted the government to build a route though upstate New York. As you might imagine, it was opposed on most fronts. First as wasteful government spending from many of Governor Clinton's allies in politics, and then simply opposed by his political opponents because it was Clinton's idea. They opposed anything he wanted to do because they simply did not like him.

(As an aside, the amount of acrimony and the level of discourse among the various political factions were far worse during that period than it is today. It is instructive to read some of the various political writings of the time. The recent biographies of Alexander Hamilton, John Adams and Ben Franklin are almost startling in the level of vituperative language that prevailed as political discussion of the time. That same level of political factionalism that was present on a federal level was alive and well in New York.)

It is a long story, and one told well by Bernstein, but eventually Clinton rounded up enough support through compromise and force of character to fund the project. Amazingly, it came in on budget, on time and the projections for tolls were quite close for the first few years, although over time, they out-stripped all projections.

Who would have thought? A private venture run by one of the great administrators and visionaries (Washington) failed while the public one succeeded in spite of politicians meddling at every turn, to the immense benefit of the rest of the country, but especially to New York, which financed the canal with state funds.

The canal opened up the west to new settlement in a way only a few visionaries imagined. With an ability to get products like grain and ores to a world market, the economic opportunity encouraged millions to move to the west. Over time, railroads become a bigger force, but the first real drive was the completion of the canal in 1826, a along time before railroads became a real factor in the US.

The canal also became a catalyst for manufacturing. All along the canal, mills and manufacturing enterprises of every kind sprung up rapidly. By 1835 there were over 13,000 various types of manufacturing businesses in New York, making products for a young nation.

The growth of businesses and commerce in that time looks like the growth of telecommunications or the spread of electricity in a later era. Just as the phone and electricity spawned whole new industries, far larger in total than the enabling innovation, the development of the Erie Canal birthed a wave of economic growth. An entire middle class was born, spurring employment and prosperity. It was not growth without problems, of course, but the die was cast.

The beginnings of the eventual economic growth of the US into its role of today was forecast by, and partly due to, the success of the Erie Canal.

To see how yet another innovation resulted in economic growth in other areas is instructive. Chicago was another city on a lake until it could be connected to the eastern shores. The mines and ores of the mid-west got an outlet to the mills in the east. A lot of cotton came up the Mississippi through later canals connecting the Great Lakes and then on through the Erie Canal to the mills of New York and new England.

When we look at the next innovation cycle, whether biotech, nanotech, robotics or energy, what will be the ancillary consequences and industries that will come from them and what will be the investment opportunities? Studying history will help us find them.

China and the Erie Canal

Finally, a few of my thoughts on China and the US. It would have been hard for the elite of England in 1826 to imagine that one day the rough and uncouth colonists, without nearly the infrastructure and wealth, education or markets, would eclipse the Empire.

Further, the English desire to protect their elite from market forces hurt them a great deal. Their consumers suffered. Yet, is there not an almost constant call from many quarters in the US to protect "American" jobs at the cost of the consumer? Rather than allowing the workers and entrepreneurs of a nation to do what they do best, and allowing market forces to re-allocate resources to the most productive members, when a government tries to interfere, it simply enshrines mediocrity and non-competitiveness.

Necessity is the mother of invention. Change is the lubricant of progress. Most of us (and now I speak to all my readers, and not just those in the US) have been the subject of the forces of the market which forced change upon us whether we liked it or not. I have had to "re-invent" myself on more than one occasion. It is not always fun, nor do we as individuals always wind up in a better place. Resisting change will mean that as a group and as a nation we will end up poorer.

I look across the Pacific and see a generation unleashed, who have seen the potential of what their hard work can bring them. They are being slowly given the power to dream their own dreams. In just 20 years they have gone from being a third rate power with nukes mired in massive poverty to a growing economic power. I can think of no story like this in history.

If the United States tries to resist change, we will retreat. If we look at China and Asia and try to protect uncompetitive industries we will not like the long-term outcome. However, if the US (and Europe) embrace change as we always have, if we allow our entrepreneurs the room to compete and find new markets and businesses, it will not matter if China becomes a larger economic power. After all, the population of China is four times as big as the US and with continued growth should eventually be larger. But we will find our lives and standard of living, and that of our children, far better in such a future.

We can better see the future by understanding the past. I highly recommend Wedding of the Waters , and if you have not yet read Against the Gods , you should pick that up as well, and get free shipping from Amazon. Go to www.Amazon.com and order the books. You will be glad you did.

The Vital Few or the Trivial Many

Wouldn't it be nice to know what the management and directors of the companies we invest in really think? The kind of inside information that gives us a signal whether to buy or sell?

One of the nice things about what I do is that I get sent a lot of books that I might not ordinarily come across. There is an imposing stack across from my desk along with the dozen or so "important" books that I want to read in my studies of the markets and history to try and get an inferential glimpse into the future; to find an edge, even if it only lasts for a short while.

I was sent a copy of George Muzea's book called "The Vital Few or the Trivial Many," which is a study of how to invest with the insiders. George has been doing this for as long as anyone I know, and offers some insights in this really rather brief monograph. As compared with most books (mine especially!), you can read this book in a few hours and pick up a number of insights that will make you a better investor.

Muzea runs Muzea Insiders Consulting Services at www.smartinsider.net. It is designed for hedge funds and institutions and is priced as such, at $20,000 per year. Basically, he catalogs all the insider trading in listed stocks, ranks them and then rates the stocks according to the trading pattern. Some of the largest firms in the world use his service to try and give them an edge. (Contact info below, for those of my readers who run larger amounts of money.)

I was able to get into contact with him, and he graciously took me through his database. I made some notes and thought I would pass them along to you as to what insiders are doing today. He also allowed me to quote liberally from his book, so we can get an idea of how to get access to our own inside information.

It is useful to listen to George. He nailed the last bear market for his clients, as insiders were selling in masses in early 2000. He called the bottom of the recent bear, as again insiders delivered the signal. (He tracks movement in industry sectors and indexes, as well as individual stocks.) Interpreting insider trades is partially an art, as George has learned not all insider trading is meaningful. Sometimes, it can even be misleading.

First of all, this type of insider buying and selling is not necessarily illegal. If you are an officer or director of a company, you can buy and sell the shares of your stock. Before Enron, you simply had to file all your trades within a 30-45 day period. Now you have to file within two days. From these filings, one can now quickly discern what is going on in the "inside." Quoting George:

"The key word that you will read many times in this book is 'divergence.' Normal insider behavior would be to buy into price weakness and to sell into price strength. Just because they are corporate insiders does not necessarily mean they are savvy investors. A minority of insiders, mostly those with Wall Street roots, understand the investment community's response to news and are very conscious of the future trend of earnings and other important developments they expect to report. The majority of insiders, however, do not have a clue as to what causes their companies' stock prices to go up or down. This group is primarily focused on the inherent value of the stock relative to its current price.

"Regardless of whether corporate insiders are focused on news they expect to report or comparative values, all insiders understand the intrinsic value of their own companies' stock. Intrinsic value is the price at which a company could be liquidated or sold to an interested buyer. When their company's stock approaches or drops below intrinsic value, insiders buy. The lower it goes, the more they buy. One the other hand, when stock prices rise above their perception of intrinsic value, insiders sell. The higher it goes, the more they sell.

"Since it is normal for insiders to buy as their stock goes down and sell as it goes up, what we want to look for are divergences from this normal behavior. Your eyes should become wide open when you see an insider, especially the Chief Financial Officer who normally sells stock only when the price rises, suddenly break this pattern by selling into price weakness. It usually means that the company's business conditions have deteriorated and that bad news is coming. On the other hand, you should really be impressed when you see insiders buy at higher prices than their earlier purchases. This usually means business conditions are at least as strong as they were when these insiders first bought, and in many cases, getting stronger. Better than expected news usually surfaces a few months later."

George later summarizes his rules (quoting):

1. Insiders normally buy into price weakness and sell into price strength; therefore it is important to look for deviations from this behavior.

2. Stocks that have insider selling (three or more insiders) into price weakness should be considered seriously as candidates to sell.

3. Insider trading by operating officers is more predictive than those of other insiders, especially outside directors.

4. When analyzing insider trading, it is important to observe previous trading patterns to see if the current trade is in line with or a divergence from normal behavior.

5 .When insiders buy stocks that are depressed in price and out of favor, much of the time the buying is a sign of value, but sometimes it is simply designed to ignite investor confidence. The best way to determine which is which is to review carefully the dollar value of the purchases. If the insiders had sold previously at higher levels, they should be buying back at least 25 percent of what they sold; otherwise, they could be window dressing.

6. Most of the time one should look for clusters of insider buyers who have all made decisions to buy stock in their companies. However, sometimes a single trade can be predictive, especially when the buying insider has a good trading history in that stock or the purchase is an unusual divergence from past behavior.

The book is a paperback and is just $13.57 from Amazon. There is an older version so make sure you get the just released one. It is a collection of wisdom and great stories from a market veteran and a wonderful story-teller. You can find it at www.amazon.com.

So what is George telling his clients today?

First, in his January 11 letter he still has sell signals on the S&P 500, S&P 400 (mid-cap), S&P 600 (small cap) and the Russell 2000, based on patterns of insider selling from December

He presciently wrote: "Last week, the media was scrambling to come up with reasons for the decline. Discussions ranged from profit taking in last year's winners to back-to-back weeks of $1.1 billion in cash outflows from stock mutual funds. It might be useful at this time to avoid headlines and government statistics and look at the market itself for clues as to how serious to take the current decline.

"In last month's review, we reported that insider selling increased dramatically in December, reaching previous top levels. At the same time that insider selling reached top levels, Investor's Intelligence Advisory Sentiment bulls was 62.9%, the highest level since January 1987 and the American Association of Individual Investors (AAII) weekly poll had 60% bulls and only 18% bears."

When you read his book, you find out that when there is a divergence between insider selling and public opinion (thus the Vital Few vs. the Trivial Many) it is an indication of major and intermediate tops and bottoms. What we are still seeing today is a very bullish public and insider selling - not a good sign. He goes on:

"In our opinion, whether or not the current decline escalates into something more sinister depends on the actions of insiders and stock mutual fund investors. The peak of redemptions and forced liquidations of stocks by equity fund managers always occurs at or near market bottoms. For example, the short- term bottom of September 2001 had net outflows of $29 billion. The actual bottom for most stocks occurred in July 2002, which had $53 billion in outflows. In both cases, insiders bought into these redemptions.

"Current outflows are modest but whether or not they cascade into double-digit outflows depends largely on the mood of the public, heavily influenced by the actions of the market and the sentiment of market letter writers that influence them. Last week's AAII poll showed bulls dropped to 38% and bears increased to 35%, a sign that last week's decline frightened individual investors. Low risk entry points occur when insiders are bullish and investment sentiment is extremely bearish into a deeply oversold market fueled by forced equity fund liquidations, often accompanied by a negative news story. None of these ingredients are in place now, and we expect it will take a much more serious decline to get what we want.

"Most short-term technical indicators are now oversold; therefore, a rally could occur at any time [and we saw one this last week, which lasted all of two days - JM]. However, long-term indicators are still overbought. For example, the percentage of stocks in up trends in our four major indexes is 70% and most market bottoms occur below 30%. With insiders still negative, we believe there is a high probability that short-term rallies will fail and the next low risk entry point for long-term investors will occur later this year. We continue to recommend portfolio managers be focused and selective in buying.

"CONCLUSION: Current insider trading patterns suggest that overall market risk remains high. We will monitor short-term rallies carefully to see if insiders sell into them. We will also monitor stock mutual funds cash flows."

But it is not all doom and gloom. There are places where there is quite a bit of insider optimism. One of those is energy, where Muzea has a sector buy based on insider buying. Looking through the group, the buying seems to be focused in various smaller oil and gas plays.

Looking at other sectors, there is strong insider buying in certain smaller regional banks.

So how does the little guy play the insider game? Muzea points out several ways. You look for companies that are making new lows, go to http://finance.yahoo.com and type in the company symbol. On the right hand column there are several listings of insider trading. If a company is down, but the insiders are buying, it is time to start your fundamental research to see if this looks like a turnaround. It is contrarian investing, and tough to do, but with a hint from the insiders that something is afoot it can be your most successful investing.

Before you buy any stock, you should perform that simple task. It is free and quick and may be worth more than all the research reports you read. Not to put too fine a point (or sales job) on the book, but if you are a stock buyer, you should pony up the $13 and buy the book to get the wisdom of a guy who has been looking at insider trading longer than most of us have been investing.

For those institutions interested in George's services mentioned above, you can contact him at his email address at gmuzea@charter.net. He will offer a free trial if you mention my name.

It's Starting to Look Ugly

To follow up on Muzea's market call, let's look at a few other thoughts. Those clever folks at The Leuthold Group noted on Wednesday that we are about to get a record January. Typically, mutual fund inflows are positive in January. Last year we saw $28 billion flowing into mutual funds. So far this month, we have seen a net estimated outflow of $9 billion. Since the markets are well off the last two days, it is likely that number is worse.

They note: "Record January On Tap? In recent years, it has become relatively rare to use the term 'net redemptions' and 'January' in the same sentence. Net outflow did occur in January 2003, but was a relatively small -$1.3 billion. But this year, January is not only shaping up to be a month of net redemptions, but record net redemptions. Unless the final three days show very strong positive cash flow (we'll have a better idea if this is the case in next week's report) it is likely that we'll be reporting a new cash flow record for January. But just not the kind of 'record' we have come to expect."

My friend and the very smart Richard Russell notes today: "Here's what I think we're seeing. The market established oversold lows on January 24 (I keep talking about those January 24 lows). Next we have the bounce off those lows, which we can call an upward correction. The longer and higher the move off the January 24 lows, the more important those January 24 lows become.

"Somewhere ahead the market will turn down to test those lows. That will be a very important test. If one or both Averages (Industrials and Transports) hold above the Jan. 24 lows, that will be an important and constructive test for the market. However, if the two Averages, BOTH of THEM, break below their January 24 lows, particularly on heavy volume, we're in for trouble, important trouble.

"To refresh your memory, the January 24 lows were Industrials 10368.61 . Transports 3454.78 . Mark 'em down, and keep 'em in mind."

The Dow is one bad session from those lows. The Leuthold Report noted that large cap mutual funds saw positive inflows. If there is investor concern over the weekend in that arena, we cold see those stocks drop as well.

Of course, there has been a lot of selling by traders prior to this weekend's election in Iraq. If they come off modestly well, they could be back in with force.

My thoughts? I think we drift down from here with a last gasp rally later in the early spring, then into an ugly summer, much as last year, with a late year rally after tax loss selling by institutions (mostly mutual funds), which must sell by October 31st, if they are to balance their gains. Will the rally recover to new highs? It did last year, but I think the economy will be seen as weaker in the winter of 2005. Thus I expect the market to be lower at the end of the year. We do not see the resumption of a real bear market until a recession is peering around the corner at us.

We saw the economy drop to a 3.1% GDP last quarter. That is down sharply from 4% the previous quarter, and some of the growth was from inventory build-up. It is like the old children's campfire scare story: "Slowly he turned. Inch by inch, step by step, until...."

Toronto, New York, CNBC and Rodeo

Saturday we go "ringside" at the Fort Worth rodeo, courtesy of John and Metta Collier. Texas rodeos are lots of fun and quite the spectacle, and Fort Worth's is one of the best. Yes, I do have the boots and the belt and the hat (I did grow up in West Texas in the country), and will dust them off, if only to embarrass my teenage son. Parents must get those small pleasures when we can. Sunday I am off to Toronto to meet with Stuart McKinnon of Pro-Hedge and then fly to New York on Monday and start an irrationally busy two days before coming home Wednesday night. Remember, this is the year I was going to travel less. My first quarter wanderings are not shaping up as a home schedule. Oh, well.

I will be on CNBC Squawkbox at 9:15 EST with Mark Haines, but guarantee no caffeine in my system this time. We will be talking about the future of the markets, and where a few opportunities lie hidden here and there.

Since this seems to be my week for book recommendations, let me mention my own book, Bull's Eye Investing. It is now in its third printing (over 50,000)and still doing well. You should go to www.amazon.com/bullseye and read the independent reviews. And that with that, I need to run as it is quite late. My best to you for the coming week.

Your still a country boy at heart analyst,

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