Does Insider Trading Predict Future Stock Market Returns?
October 19, 2023 | InsiderSentiment.com Team
There are thousands of academic publications over the past 60 years that have looked at the predictive ability of various measures of insider trading. These studies find that insider information is highly informative and predictive of future stock market returns. This being the case, is there any strategy we can enact using insider trading indicators? If so, will it be a profitable strategy? To go further, can we use insider trading to enhance a passively invested strategy using an index like the Russell 2000? In this piece we will explore such an investment strategy using the Insider Sentiment Tracker on InsiderSentiment.com as a measure of aggregate insider trading activity.
We will show that, compared to passively investing our wealth in the Russell 2000 index, incorporating insider trading in our investing strategy over the last 10 years would have allowed us to more than double the return we receive while greatly reducing the risk.
Background
Of all the traders in the equities markets, insiders are the most informed. This is true not just in the U.S. but, in fact, globally. The number of academic studies that fail to find information on insider trading are just a few exceptions to the general rule. Furthermore, these failing studies usually get corrected after a while. Here, however, we have a focused question at hand. We want to know how good insider trading has been over the last ten years. What are the risks of following insider trading, using the Insider Sentiment Tracker on InsiderSentiment.com, if any?
Our time period is approximately the last ten years. We chose the Russell 2000 index since it is a broad-based index, while the cap-weighted stock market returns (say S&P 500) have been very top heavy recently, with the S&P 7 dominating S&P 493 handily. Furthermore, to make sure our strategy is easily implementable, we chose RUT, an investable ETF that tracks the Russell 2000 index.
We start with a passive investment of $100 in the RUT starting in September 2013 to establish our comparison benchmark. We invested $100 in September 2013 and remained invested fully until September 2023. The dollar value of our resulting portfolio is shown in the graph below. First, we can see that RUT has been relatively flat from September 2013 to February 2016, as our cumulative portfolio value remained near $100 during this period. After this, the Russell 2000 grew to $158 by July of 2018 and then declined to $104 by February 2020, wiping out about one-third of our portfolio. Then, the Russell 2000 started another bull run and reached over $200 in 2021. Finally, another bear market set in in 2022, reducing the final portfolio value to $167 by September 2023. Thus, over a ten year investment period, the Russell 2000 earned a total return of about 67%.
Comparing the Russell 2000 and the Insider Sentiment Tracker
We’ll now see if we could improve our investing performance using guidance from insider trading via the Insider Sentiment Tracker. The Insider Sentiment Tracker shows essentially the share of companies that are experiencing net insider buying, along with some proprietary adjustments to extract signal.
To get a more detailed picture, below we show both the monthly returns to the Russell 2000 as well as our Insider Sentiment Tracker together. Over the past ten years, the Insider Sentiment Tracker has averaged around 26%. A value of 20% represents a relatively low reading, while a value of 30% represents a relatively high reading, as most of the time the index stays between 20% and 30%. The biggest peak (60%) occurred in March 2020 after the stock market bottomed in late February and early March of 2020, while the lowest trough (15%) occurred very recently, in July 2023.
Careful observers of the graph below will also notice that the Insider Sentiment Tracker leads the stock market returns by about a month. For instance, it is easy to discern that the red peaks tend to follow the blue peaks, while the red troughs also follow the blue troughs. Hence, Insider Tracker clearly leads RUT. This finding suggests that the Insider Sentiment Tracker can provide possibly useful information regarding the future direction of the broad stock market.
Did Insiders Predict the Russell 2000 During COVID?
To see the lead-lag relation between the Insider Sentiment Tracker and the RUT more clearly, let us focus on the COVID period. The graph below clearly shows that in February 2020 as the COVID period started, the stock market declined, while the Insider Sentiment Tracker started to send a “buy” signal by rising above 30%. Hence, by the end of February 2020, insiders had already turned highly bullish against all the panic and hysteria in the market. We find this fact remarkable. Insiders continued to be extremely bullish, as the stock market first tanked further and then started a mild recovery in March 2020. The Insider Sentiment Tracker remained bullish (above 30%) until July 2020 while the stock market enjoyed five consecutive months of healthy, positive returns. Finally, following the first negative insider sentiment reading in July 2020, the first post March-2020 stock price decline in RUT occurred in August 2020 with a return of -3.5%. Thus, the evidence below shows that not only that insider trading via the Insider Sentiment Tracker predicted future stock market returns, but that it had a perfect record during the COVID period.
How Well Did Insider Trading Predict the Russell 2000 Outside of Covid?
While the stellar performance of the Insider Sentiment Tracker during the COVID period is interesting and commendable, we would like to know how well Insider Sentiment Tracker performs outside the COVID period as well. To track the general performance of Insider Sentiment Tracker, we engaged in the following investment strategy also from September 2013 to September 2023. In September 2013, we again started with $100. Each month thereafter, we examine our own Insider Sentiment Tracker. If at the end of the month, the Tracker equals 26% or higher for the month, we invest all of our money in RUT. If the Tracker is below 26%, we sell all of our investment and put the money in a non-interest-earning checking account. We call this the “Tracker-UP” strategy.
Second, we also invest in what we will call the “Tracker-DOWN” strategy. This will be the opposite of the “Tracker-UP” strategy. Again, we start with $100. Each month, we examine our Insider Sentiment Tracker. If at the end of the month the Tracker is below 26%, we invest in RUT. If the Tracker is 26% or higher, we sell our investment and put the money in a non-interest-earning checking account. This, again, is the “Tracker-DOWN” strategy.
You will notice that this is an implementable strategy for investors, since we only use the previous month’s information to make our investment decision for this month. Furthermore, this is also a conservative strategy, since we earn zero interest while we are out of the stock market. Looking at our Tracker, it gave us 49 “UP” signals and 71 “DOWN” signals during the past ten years.
The cumulative dollar returns to the “Tracker-UP” and “Tracker-DOWN” strategies are shown below. Just looking at the overall performance, the Insider Sentiment Tracker has done fabulously over the past ten years, from September 2013 to September 2023. The “Tracker-UP” strategy has grown from $100 to more than $200, or a gain of more than 100%, during the 49 months with “UP” signals. Again, our “UP” strategy remains invested in a checking account most of the time with essentially zero risk. In spite of this, the Insider Sentiment Tracker “UP” strategy more than doubled our investment. We also note that UP strategy handily beats a passive investment strategy of staying fully invested in RUT.
In contrast, the “Tracker-DOWN” strategy has destroyed wealth, turning the $100 initial investment to about $82, or a loss of 18% during the 71 “DOWN” months. Notice that when we compare the DOWN strategy against a passive investment in RUT, we end up with $82 instead of $167, hence losing more than half of our potential investment. Thus, going against insiders was much worse than a passive strategy of staying fully invested in RUT. Hence, we can clearly state that following InsiderSentiment.com’s Insider Sentiment Tracker has been very successful over the past ten years in predicting future stock market returns.
Strengthening the Signal
However, we can already hear the critics among you. Yes, the Insider Sentiment Tracker has done very well overall, but it is not perfect. The “Tracker-UP” strategy did not outperform the “Tracker-DOWN” strategy until about the COVID period. There have been a few years where even the reverse was true, when “Tracker-DOWN” actually performed better than the “Tracker-UP” strategy. There seems to be some risk involved in following the Tracker in this way. Here, we do not dispute these critics. It is true that the Insider Sentiment Tracker strategy is not perfect and does have some downside risk.
To determine if we can mitigate some of these risks, we constructed a revised, more improved strategy. Once again, we start with $100 in September 2013. Each month thereafter, we examine our own Insider Sentiment Tracker. If at the end of the month, the Tracker equals 30% or higher, we invest all of our money in RUT. If the Tracker is below 30%, we sell all of our investment and put the money in a non-interest-earning checking account. We call this the “Tracker-STRONG-UP” strategy since we only invest based on strong insider signals.
We will also compare this strategy with its opposite: Again, we start with $100. Each month, we examine our own Insider Sentiment Tracker. If at the end of the month the Tracker is below 20%, we invest in RUT. If the Tracker is 20% or higher, we sell our investment and put the money in a non-interest-earning checking account. We call this the “Tracker-STRONG-DOWN” strategy.
Using stronger signals, we get 30 “buy” signals and only 18 “sell” signals. Hence, most of the time, our investment is in a checking account, with zero risk and zero interest. The readers will notice that this is also an implementable strategy, since just like before, we only use the previous month’s information to make our investment decision for this month. The results of the improved strategy are shown below.
The graph above clearly shows that we simultaneously could have improved our performance and reduced the risk by using stronger insider trading signals. Using “STRONG-UP” signals, we are able to convert a $100 investment into more than $230, after only 30 monthly purchases. This is a 130% return in only 30 months, or 2.5 years of investment time. Compared to a passive strategy, that is a doubling of the dollar returns while invested only one-fourth the time. Again, this is a remarkable performance. Being invested in the stock market while getting a strong insider “DOWN” signal again destroys wealth, turning $100 into $85 after only 18 months of investments. Again compared to a passive strategy, we lost about half the value of our portfolio.
Another clear take away from the strong signals experiment is that, in the historical period, it reduces and eliminates the risk of underperformance. “Strong buy” signals dominate “strong sell” signals, not just during the COVID period, but during the entire ten-year investment period, as the “STRONG-UP” strategy never underperforms the “STRONG-DOWN” strategy. Moreover, we can see that while there are some dips in performance, our “STRONG-UP” strategy never loses any part of our initial investment of $100.
Conclusion
While passively investing in the Russell 2000 alone gave us a 67% total return over 10 years, harnessing the power of insider trading via the Insider Sentiment Tracker was able to improve our total return to 100%. Acting on only strong insider signals gave us a whopping 130% return over the 10 year period. Further, using strong signals allowed us to greatly reduce the risk over the investment period. This is quite an impressive feat considering that 75% of the time, our entire portfolio is in a zero-risk, zero-return checking account. In moving in and out of the RUT using insider sentiment, we were able to improve the Sharpe Ratio (a measure of reward-to-risk) of the portfolio from 0.21 in the RUT-only strategy to 0.68 in the Tracker “STRONG-UP” strategy. Hence, using the Insider Sentiment Tracker more than tripled our reward-to-risk ratio.
Our “STRONG-UP” strategy is just one of the simple improvements we can make. We can and we have refined our investment strategies to further improve performance and reduce risk. For all of our subscribers, we provide daily updates to our Insider Sentiment Tracker. For our professional subscribers, we can construct even more sophisticated, customized as well as on-demand strategies.
While past performance does not guarantee future performance, the bottom line is that following the Insider Sentiment Tracker is probably a good strategy for most financially-savvy investors. Subscribe at InsiderSentiment.com to start getting the signal for yourself.
Note: The above should be thought of as an academic research exercise and not testing an investment strategy. This is because the Insider Sentiment Tracker is captured to use at the time of writing, and realizations of the Tracker change somewhat over time as late transactions are filed.
Authors’ disclosure: This article expresses the authors’ opinions. None of the authors have any business relationship with the company whose stock is mentioned in this article. None of the authors have any stock or derivative position in the company mentioned in this article, nor any plan to open such a position within 72 hours. The article does not constitute any recommendation or advice as to whether any investment is suitable for any particular investor. Consult with your licensed financial advisor before making any investment decision.