Insiders to Investors: Look Out Below!

Disappointing numbers from IBM(IBM Quote), Microsoft(MSFT Quote), Intel(INTC Quote) and others foreshadow that the rebound in the tech sector -- services, software and hardware alike -- is hardly nigh. And gloomy news from WorldCom (WCOM Quote), Ericsson(ERICY Quote) and, well -- you name it -- indicate that telecom's resurgence is a year off at best.

"This isn't how it was supposed to be" began an article in one Wall Street paper of record in late April, as it lamented the poor showing of some of the world's highest-profile firms. Well, this may not have been what their average reader expected, but InsiderInsights subscribers were tipped off long ago that the market had gotten ahead of itself.

Credit for this foresight goes directly to insiders, however -- I only interpret this data. And the bearish levels of my Insider Market Indicators (presented in a chart each week in InsiderInsights) made me focus on the potential negatives in this market instead of the chirpy economic news that was setting many investors atwitter.

Unfortunately, insiders seem to expect the indices to weaken further. The insider buy/sell ratio for April, which is used to plot the Market Indicator, was officially the most bearish since I began collecting the data in the mid-1990s. There were 90% more companies with insiders filing Form 4s indicating sales vs. purchases.

More Pain Ahead? Insider Market Indicators foretell a big dip in the market

Source: InsiderInsights.com

This is not a good sign, and investors would do well to increase the cash portion of their portfolios, and even think about shorting an index. If history repeats, it will take a hefty market decline to make my Market Indicators rise to more typical levels.

Indicators' Track Record

In the fall of 1998, when the market plummeted and the Indicators spiked bullishly, I was able to pound the table and say that the "Asian Contagion" would not affect stocks for long. Insiders continued to say the market was a good buy in April through May 1999, and when many thought the bull market was dead at the end of 1999, I could once again announce that decline as a buying opportunity.

The Indicators were more neutral than bearish before the massive decline in March 2000 (likely because insiders were never buying the types of stocks that truly crashed and burned), but insiders served us well a year later when they indicated that the market rally in early summer of 2001 would likely be short-lived. Insiders were bearish right up till the Sept. 11 debacle, and then told us the aftermath was a huge buying opportunity.

Alas, the bullish sentiment ended when stocks rebounded to their pre-September levels, and insiders' old worries of economic and earnings weakness returned. And there insiders' market sentiment has sat -- correctly so.

Five of the past six recessions have been double-dips, and this economic recovery has numerous weaknesses that could make that statistic six out of seven. I've been pointing out potential problems for the past few months in my newsletter, and the basic premise I've been working on is that the good economic news that began pouring in earlier this year was already priced -- or rather, overpriced -- into the equity market.

Besides near-term earnings disappointments and accounting scandals, we've seen high consumer and corporate debt, a high U.S. current account deficit, inevitably rising interest rates, a potential weakening of the housing market and foreign investors potentially becoming less keen on U.S. assets. All these factors have jumbled together to cause real concern about the ability of U.S. equities to tread water.

Stop the Losses

Not being a short by nature, I knew I'd feel the pain from the market downturn when it came. Not knowing when the fall would occur, I've been keeping myself in a position to prosper should the market continue up, but have acted on my bearishness by repeatedly advocating the use of stop losses to protect gains and limit losses.

This policy certainly served me well in the past weeks. Although the 34 positions on InsiderInsights' Recommended List lost 2.8% on average during the week ending April 26, that was less than the 3.1% and 4.3% drubbing the Russell 2000 and S&P 500 indices took respectively. And even after the fall, the average return for these 34 positions was 30% over an average 15.5-week holding period.

As stocks like Allegiance Telecom(ALGX Quote) and Vitesse Semiconductor(VTSS Quote) have been taken down, the damage was limited on my Recommended List to losses of 14.4% and 10%, respectively. Meanwhile, other stocks held ground and even appreciated.

Corio(CRIO Quote) popped for us quickly out of the gate, going from $1.18 to $1.88. But now it's back where it started. By ratcheting up the stop loss to protect profits, InsiderInsights got out at $1.50 and bagged a 27.1% profit in just over a month. Valuewise, I think Corio is arguably a buy again after its round trip, even after its less-than-stellar quarter. But in this market, there is probably no hurry to place my second bet.

Now let's talk about (ugh!) Icos(ICOS Quote). I hate to say it, but newsletter subscribers learned of my being stopped out of this position the day before the Food and Drug Administration dropped its bomb on the stock. I had a 4.9% loss on this position. It's unfortunately not possible to update all the stocks I mention in my weekly RealMoney column, but anyone looking at Icos' chart the week before the collapse could see the weakness.

What to do with Icos now? I think the selloff is overdone, and I've added it back to my Recommended List. Even if Bayer's erectile dysfunction drug hits the market before Cialis, I think Icos' offering will garner enough sales to bolster its stock. Both of the new drugs are more effective than Pfizer's(PFE Quote) Viagra, and a reported 80% of men suffering from dysfunction have yet to seek treatment.

Despite obvious problem positions, InsiderInsights' approach of using insiders as a first screen to determine where to focus fundamental research is working well in a horrible market.