This column was originally published on RealMoney on Aug. 23 at 12:38 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.
My recent columns have relayed my increasingly bearish opinion about the near-term prospects for the indices. Unfortunately, that feeling only increased last week.
My now-enhanced insider-based market indicators have produced a sell signal that I'm not ignoring. I'm taking protective measures for the further market weakness my indicators show is likely, and even taking a bet against the indices. While I'm not all-out bearish here, I am applying discipline.
Applying Last Year's Lessons
I made the mistake last year of sitting too long while I lost hard-earned profits to a cruddy market patch. I already have shown more discipline during this recent leg up for the indices by taking profits in, among others:
- Titanium Metals (TIE) ;
Smith & Wesson( SWB);
Pentair (PNR) - Get Report; and
PSS World Medical( PSSI).
I also cut my exposure to some positions that have become less-attractive plays for the short term, like
. While I still like them longer term, slight disappointments recently weakened their charts' technicals. That could make them more vulnerable in the short term, should the market weaken more.
These actions have translated into a steady raising of cash as well. Over the past month, I have moved from having just 10% of my stock portfolio in cash to 50%, as of last week. That's extremely high for me.
I have not completely given up on deep-value investment theses that lack near-term price momentum, however. I still have buy ratings on a couple of micro-cap companies, and have even taken advantage of their stocks' present weakness to trickle more money into them. Only time will tell if I am making a mistake by sticking with these longer-term plays instead of getting out of them now and hoping for a better entry point. But given the more prudent moves I've made with the rest of my portfolio, I don't believe it's too risky to stay the course with selected deep-value plays.
Another mistake I made last year was being short the market too aggressively when the indices were testing downside support after falling for weeks. Hindsight shows that the indices were resilient at those very critical technical levels. However, a look back also shows the indices in something of a trading range, a pattern that I still believe is basically intact. Trying to make some money during the down legs is not wrong; it's just a whole lot trickier.
To try to catch weakness in the indices earlier this time, I have overlaid five technical and sentiment approaches to my insider-based market indicators, which I'll explain below. Using this combined approach, I finally am ready to take a bet against the indices again. For this purpose, I am buying
ProFunds UltraShort Small-Cap Fund as a leveraged bet against the Russell 2000 Index. Specifically, the UltraShort ostensibly moves twice the inverse of the daily performance of the Russell 2000. So, if the Russell moves down by 1% on a given day, UltraShort should move up 2%. Of course, the opposite is true as well, and any readers interested in taking this approach need to determine how much of such a fund is appropriate for their portfolios.
Why So Glum?
Now that I've related my actions, let me explain why I've been growing increasingly bearish. The rolling four-week average of my insider buy/sell ratios (as plotted in the dark black line on the graph below) appears to be at an inflection point. The plot troughed at -230% for the week ending Aug. 5, and has risen to -188% in the latest week. A buy/sell ratio of 230% means that there have been 230% more companies with one sort of insider activity than the other. The negative sign indicates that it's the selling activity that is reigning supreme.
A Selling Inflection
Inflection points are of particular interest to my methodology. Prior to July 2003, buying opportunities corresponded with downward inflection points in my indicators after they had crossed over into positive territory, usually to at least positive 20%. Market weakness tended to correspond with upward inflections in my indicators, after the indicators had crossed below negative 20% or so.
Since July 2003, however, the thought of my ratios rising back to "only" negative 20% seems quaint. They have fallen off a cliff, along with most other insider-based ratios. Some have discounted the sinking insider sentiment as somehow flawed by a sudden change in the reasoning and method insiders use when making their trades. Option-related sales and 10b5-1 programs (known as automatic selling) both have been cited as explanations for the chronic bearishness of executives.
I am not among those discounting the sentiment. Research I published back in my
March 8 column argues specifically against option-related sales as unreasonably skewing my ratios south. And when I trace back most 10b5-1 programs, a great many merely follow a long string of open-market sales. That indicates that insiders probably would have continued to make their sales in the open market, if not for the legal coverage 10b5-1 plans afford.
But my primary need is to profit from any change in reality. Explaining any change is secondary, though my research at this level continues. To this end, I have been forced to interpret my ratios differently since July 2003. After all, the indices are up since then, despite the outrageous bearishness of insiders. Getting past the absolute level of my ratios, I note that the major inflection points in my indicators still tend to correspond with major changes in market direction:
- mid-May 2005 (bullish);
December 2004 (bearish);
September 2004 (bullish); and
March 2004 (bearish).
Inflection points at those times proved very accurate. But there have been a few head-fakes since the 2003 collapse in sentiment. Most of them occurred in 2003 itself, and all were incorrectly bearish.
Acting on those head-fakes in my usually reliable insider-based market indicators cost me performance in both 2003 and 2004, before the change in interpretation became obvious. To guard against making more tactical, top-down errors, I have overlaid five technical and sentiment approaches to my insider-based market indicators. I employed this new approach to good effect just a few months ago, when these other systems confirmed my indicators' mid-May inflection point. This allowed me to confidently -- and correctly -- get fully invested then.
In the past week, this combined approach finally produced a good-quality "sell" signal. Hence, I am raising cash levels again and taking a bet against the Russell 2000 index.
Note that I am not using this opportunity to advocate betting the farm on a severe market decline. History shows that it is often thankless to get too bearish. Timing big bearish bets correctly is also extremely difficult. What my present call is firm on, however, is that the odds of further market weakness of unknown length have risen to unacceptable levels, and that it is prudent to take some action to protect your portfolio against that further weakness.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Smith & Wesson and VistaCare to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
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At the time of publication, Moreland was long Smith & Wesson, VistaCare, Alliance Gaming and the ProFunds UltraShort Small-Cap Fund, although holdings can change at any time.
Jonathan Moreland is director of research and publisher of the weekly publication InsiderInsights, founder of the Web site InsiderInsights.com and the director of research at Insider Asset Management LLC. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, Moreland appreciates your feedback;
to send him an email.