Corporate insiders are giving the stock market the benefit of the doubt, despite the market’s early-October plunge.

For the record, I should stress that the insider trading to which I refer is the legal kind: transactions by a firm’s officers, directors, and largest shareholders, and reported promptly to the Securities and Exchange Commission. It’s possible by slicing and dicing the SEC data to come up with portfolios that, generally, have beaten the market by a significant margin.

Yet the past several years have been difficult for these insider-based strategies. Consider three mutual funds that have based their stock selection on the behavior of insiders. As you can see from the accompanying table, they have mostly lagged the S&P 500 in recent years. (The table’s data is courtesy of investment researcher Morningstar.)

The sole fund with a 10-year record — the NFO ETF — in fact has beaten the S&P 500 over the past decade. Furthermore, some of these insider-oriented funds — NFO and KNOW especially — are more heavily weighted to small-cap stocks than the S&P 500, and so a small-cap benchmark such as the Russell 2000 index might be a fairer comparison.

Furthermore, Nejat Seyhun, an expert on the investment significance of insider trades, told me in an interview that he’s found no evidence in his research that insider trades in recent years “have any less information content” than those of several decades ago.

The last time I reported on the investment implications of Seyhun’s research, “corporate insiders [were] betting that Dow 20,000 will be just a way station on the road to higher levels.” At the time of that column, of course, the Dow Jones Industrial Average had just broken the 20,000 barrier; it today is above 25,000, more than 25% higher, even after the market’s recent plunge.

Seyhun’s interpretation of the insider data relies on two crucial insights:

  • Trades undertaken by certain insiders — officers and directors — are worth paying more attention to than those executed by the third type of insider (a firm’s largest shareholders). Because the SEC throws all three types of transactions into a single “insider” category, and because transactions incurred by the largest shareholders tend to be far larger than those of officers and directors, the raw data can often paint a skewed and misleading picture.
  • Care must be exercised to avoid giving undue weight to insider transactions at the largest companies. One big insider sale from a large-cap company, for example, could represent a greater dollar amount than the total of all insider purchases from several hundred small-cap companies. For this reason, too, the raw data can be misleading.

Taking these two factors into account, Seyhun focuses on each company individually, and then only on transactions executed by that firm’s officers and directors. He then calculates the percentage of all firms with recent insider transactions for which there has been net buying. Such an approach, of course, gives equal weight to both the smallest- and the largest-cap companies.

Currently, according to data provided by Professor Seyhun, this net-buying percentage stands at 27.5%, slightly higher than the 10-year average of 23.8%. Even though he classifies this current percentage to be in the “neutral” category, Seyhun noticed that it is still slightly higher than the long-term average and therefore means that insiders are “giving the market the benefit of the doubt.”

Note carefully, however, that the greatest explanatory power of the insider data exists at the one-year horizon, according to Seyhun. So even if the insiders are right to give the current stock market the benefit of the doubt, it’s still possible that the current correction could go further, both in terms of time and magnitude, before recovering a year from now to a higher level than today.

Those following the lead of corporate insiders would favor the largest-cap stocks.

In addition to calculating this net-buying percentage for the entire stock market, it’s possible to do so as well for individual sectors of the market. Currently, for example, the percentage for the large-cap sector of the market is 56.7%, according to Seyhun’s calculations, versus 20.8% and 18.6% for the midcap and small-cap sectors, respectively. Those following the lead of corporate insiders therefore would favor the largest-cap stocks for performance in coming months.

Among industry groups within the large-cap sector, the following are those for which more than half of all firms have net insider buying, according to data from Seyhun:

  • Energy
  • Health care
  • Materials
  • Real estate
  • Telecommunications

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