What the End of 2007 Showed


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Giorgos Siligardos

28 Jan, 2008

in Fundamental Analysis and 1 more

The end of 2007 was characterized by extreme values in various indicators of stock market analysis. In this article I will review and analyze four of them. I will use the term “indicator” here not necessarily according to the technical analysis jargon but rather as a set of clues (either measurable or not) under the same idea which can reveal specific internals of the stock market and imply bullish or bearish projections.

The First Indicator: Commercials Versus Small Speculators
The Commodity Futures Trading Commission releases weekly information known as Commitment of Traders (or simply COT) report about various markets which can be used to approximate the net open interest for futures and options in each of the following three categories of market participants: Commercial Hedgers, Large Speculators and Small Speculators. The commercial hedgers (or simply commercials) are those who use the markets for hedging while the speculators are those who try to profit from the market itself. The discrimination between large and small speculators is based on their average trading volume. Among the three categories the information regarding the commercials and the small speculators are the most important. As a rule of thumb, the commercials are usually right and the small speculators are usually wrong. There is a plain explanation for this: On the one hand, the small speculators include the “uninformed public” which is trying to accumulate wealth in a very short period from the market swings and on the other, the commercials are hedgers who use the markets to reduce risk and make money in their businesses. The latter group consists of those who know their business inside out. A useful book dedicated to the COT reports is Larry Williams’ “Trade Stocks and Commodities With the Insiders” ([4]).

Two things must be stressed with respect to commercials’ behavior in the markets. The first is that even though the net position of the commercials is quite informative, the fact that they do not attempt to profit from the market swings makes them more sellers than buyers. It is generally unusual seeing them being net long for a market for a prolonged period. In effect, we are interested mainly in extreme readings of the commercials’ net interest relative to the past. The second is that the reflections of the commercials are those of a giant dinosaur. They change their positions gradually and usually much earlier than the actual market turn. Bearing this in mind, take a look at figure 1 where the recent activity of commercials and small speculators for futures and options on SP500 is illustrated.

It is apparent that during the last quarter of 2007 the commercials and small speculators had completely different opinion about the future prospects of the stock market. It is interesting that not only the commercials were net long but also they had the largest multi-year net position (not shown in the chart). This is clearly one of the most bullish signals one can get from the study of the COT report but there is more.

In figure 2 you can see a similar chart this time showing the net open interest of commercials and small speculators for crude oil. Higher prices of crude oil are generally viewed as inflationary and thus have a negative impact on the stock market. It was mentioned before that the commercials are generally sellers thus usually having negative net positions and this was the case for the crude oil for 2006 and 2007. Bearing this in mind it is the extreme cases or deviations from this behavior that raises the alarm that something is going on. Notice that though crude oil is in a strong uptrend during the last months of 2007, the commercials have taken a very negative net position which can be seen as a bearish forewarning for its price and a positive indication for the stock market in the long run. It is not the negative net position of commercials that produce the bearish sign for crude oil but rather the magnitude of their position in relation to their position for the past 2 years. The information from figure 2 alone is not sufficient to conclude meaningful opinions but when seen in conjunction with the chart from figure 1 the conclusions are plain as the day.

The Second Indicator: Aggregate Activity of the Insiders
Insiders are defined as officers and directors having decision-making authority as well as owners of more than 10% of any equity class of securities. Insiders are required to report to the Securities and Exchange Commission all of their buying/selling activity at specified times following their transaction. It is obvious that monitoring the stock purchasing or selling clusters of the people who work at the company (and specifically of the people who are in the driver’s seat) gives significant clues about the prospect of the company. In effect, monitoring the aggregate activity of insiders for all stocks gives significant clues for the whole stock market. Two things must be taken into account when examining insider activity. First, the insiders are usually sellers. Larry Williams reports in “The Right Stock At The Right Time” ([5]) that since many corporate executives are compensated with shares as well as salaries, the normal sells/buys ratio for the insiders is about 2.5 while others consider that this ratio is much greater than that. Second, insiders normally buy into price weakness and sell into price strength therefore, as George Muzea pinpoints in “The Vital Few vs The Trivial Many” ([1]), it is important to look for deviations from this behavior. Generally, insider buying during an uptrend is much more bullish than insider buying during a downtrend and selling during a downtrend is much more bearish than selling during an uptrend. Additional sophisticated concepts relative to the interpretation of insiders can be found in Muzea’s book and result reports concerning the usefulness of SEC filings can be found in “Investor Intelligence from Insider Trading” by Nejat Seyhun ([3]). My research on a number of stocks shows that in terms of both quantity and quality of the difference between the aggregate insiders’ buy transactions and aggregate insiders’ sell transactions for the last months of 2007 were in multiyear highs and as mentioned above this is a very strong bullish sign.

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Excellent article Giorgos, certainly up to your regular standard. My only comment is that insider buying especially in rallies is far more accurate than trying to interpret insider selling for one very good reason. Insiders often rely on stock options and restricted stock that becomes free trading as part of their income so high levels of selling more often coincide with quarter ends when they are allowed to sell as opposed to dumping shares because they think challenging times are ahead for the company.

Insider buying on the other hand is done for two reasons. 1) more commonly they are prepared to trade real money for shares when they believe their company's stock has a high potential for appreciation or 2) they are trying to fool the public into believing that insiders have great faith in the prospects of the company by buying a few thousand shares...

Mar 21, 2008

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