When the Insiders Stop Trading
What the sound of silence can tell us about a firm
Investors often scrutinize the trading activity of insiders for insights into a corporation’s prospects. In theory, the buying and selling decisions of insiders—and, in particular, those of officers and directors—should be informative. After all, who should know better whether a stock has lasting value than the people who run the company?
Over the long run, this tends to be true, but, according to George Gao, assistant professor of finance at Johnson, it is the absence of insider trading that is the surest tipoff of impending extreme news about a company. In a recent working paper, “The Sound of Silence: What Do We Know When Insiders Do Not Trade?,” Gao and co-author Qingzhong Ma, assistant professor of finance at the Cornell School of Hotel Administration, show that insiders sharply reduce their trading in advance of major news about a company, whether good or bad.
“Insiders are highly motivated not to trade when they know anything that hasn’t yet been revealed to the markets,” Gao explains. Trading by insiders is regulated, and it is generally illegal to trade on material, non-public information. Penalties for illegal insider trading can be severe, including fines and jail time. The result is that the curtailment of insider trading in advance of major company news is usually so significant as to be easily distinguished from normal trading activity.
Gao and Ma’s work appears to be the first to shed light on this phenomenon. “What is interesting about trading silence,” says Gao, “is that right now the markets don’t seem to fully incorporate the information that trading silence can convey.”
In a sense, says Gao, insider trading restrictions create a form of market failure, as they tend to bottle up extreme news about a company, delaying and intensifying its impact on the markets. The price reaction typically happens all at once, when earnings are announced, even when the factors leading to the news have been building up over time.
One challenge in studying insider silence is that, when examining broad samples of companies, very good results from some firms tend to cancel out the very poor results of others. Gao and Ma’s key innovation was to develop methods to sort out the companies that eventually reported bad news from those that reported positive news, creating samples in which the implications of silence could be isolated and studied.
The authors chose merger announcements and bankruptcy filings as the most common and easily-identified forms of extreme news about a company. In a large sample of mergers between 1992 and 2010, they found that insider trading in the shares of targeted companies dropped sharply in the months preceding a deal announcement. More than six months before an announcement, insiders were net buyers in eight to ten percent of target firms; in contrast, only three percent showed net insider buying in the announcement month. Furthermore, this sharp drop in trading activity only appeared in friendly deals, of which insiders were likely to have advance knowledge, and not in hostile acquisitions, which are usually a surprise to insiders.
The researchers found a similar pattern among firms that filed for bankruptcy during the same period. Net insider selling fell from about 10 percent of companies in the 30th month before a filing to about five percent in the month immediately preceding bankruptcy.
Gao cautions that insider silence alone cannot offer much guidance to investors. “If insiders stop trading, it’s likely an indication that something extreme is probably about to happen to a company—but it doesn’t tell you whether it’s going to be good news or bad news.”
In search of an advance indicator of a company’s direction, Gao and Ma also chose to examine the level of short interest in companies’ stocks, which a large body of research has shown to be a good indicator of future returns. They identified stocks among their sample with high and low levels of short interest, and examined the outcome for stocks in which insiders stopped trading.
What they found was that the combination of high levels of short interest and a curtailment of insider trading proved to be a powerful indicator of impending bad news. A low level of short-selling and insider silence did not yield a comparably clear signal on a company’s direction.
What are the implications of these findings for investors? Insider silence has limited usefulness to investors seeking to benefit from mergers and acquisitions, explains Gao, as it is too difficult to figure out which firms are likely targets or acquirers. But, he says, “if you hold a stock and see that it is being heavily shorted and insiders have stopped trading, dump it now!”
Hedge funds and deep-pocketed individuals also may consider actively shorting companies that exhibit insider silence and high levels of short interest. However, the risks involved in this strategy—along with technical problems, such as the difficulty of obtaining shares to borrow when a stock is already being heavily shorted—make it tough to implement for all but the most sophisticated investors.
By John E. Young