Are Insiders Buying or Selling?

As the stock market has taken a little early-year breather, investors are left pondering the significance of the pullback. Is it a preamble to a larger, more sustained decline, or just a small break on the market's continuing path up? Well, who better to judge the prospects of our nation's business sector than the very insiders who work at these companies?  

The inside track
Insider buying activity is giving us some positive signals right now. MarketWatch recently noted that according to Argus Research data published in Vickers Weekly Insider Report, the ratio of sales to purchases for company insiders has fallen from 5.15 to 1 at the market's peak in mid-January down to 2.42 to 1 in the past week. That means these insiders, as a group, generally believe that their company's shares will appreciate and are "buying into" the current market drop.

Of course, company insiders aren't always right, but insider buying activity can be a useful barometer of business optimism and future expectations. Because many corporate insiders sold substantial amounts of stock last year even during the rally, it's encouraging to see them buying now. And the place where most of the buying is taking place is on the smaller end of the scale. In the past month, the number of small-cap companies reporting insider buying has increased 35%, while mid-cap companies experienced a 19% increase, and large caps with insider buying actually dropped 3%.

Small fries take the lead
If we take a look at some of the largest recent insider trading transactions in the past month, here's what we find:

Purchases

Source: MSN Money, Yahoo! Finance.

Sales

Source: MSN Money, Yahoo! Finance.

Now it's true that some of those "insiders" are actually institutional investors with 10% stakes in companies, and they have to report transactions the same way that company executives do. But still, does all the activity in smaller stocks mean that small caps are the place to invest right now? Not necessarily.

First, it's important to note that insider buying at small-cap companies tends to precede buying at larger companies in the economic cycle. So we're likely to see large-cap insider buying pick up later. Furthermore, executives at smaller companies generally have more to gain from buying company shares in terms of potential capital appreciation than would someone at a large blue-chip company.

But beyond that, while near-term optimism for stocks may be on the rise, the time may be drawing neigh for a shift in market leadership. While small caps have historically outpaced their larger-cap counterparts over very long periods of time, their dominance tends to run in cycles. Smaller fare has undoubtedly been in favor over the past decade. Just check out the returns on two broad-market large-cap and small-cap indexes:

Source: Morningstar Principia (through Jan. 31, 2010).

Small caps have had a nifty run in recent years, leaving larger companies in their dust. But given their recent outperformance, and current business conditions that are hitting smaller companies harder than in previous recessions, I don't think they're going to be the superstar standouts looking ahead.

Large and in charge
In my opinion, large-cap stocks are hands-on favorites to outperform this year. According to Bloomberg data, of the 70% of large-cap companies that have reported fourth-quarter earnings, the earnings per share of S&P 500 companies have grown by 47% versus a year ago, which is almost 12 percentage points ahead of analyst expectations.

Small-cap companies, on the other hand, are running into a bit of trouble. Of the half of the S&P 600 companies reporting for the fourth quarter, earnings are up 30.4% from a year ago, but that's 8.6 percentage points less than analysts expected. Small-cap revenues are also down 0.3%.

Given that the economic environment is especially tough for smaller companies, it's not surprising that they may be struggling. While larger companies have benefited from a thawing in credit conditions, financing remains difficult for smaller companies to obtain. That could portend further difficulties for this sector.

Ultimately, it's reassuring that company insiders in the know are using the current correction as an opportunity to buy stock at a temporarily lower price. They're taking advantage of that whole "buy low" recommendation, which more investors might want to think about doing as well. Take this opportunity to position your portfolio for any potential near-term rebound. Large-cap stocks are much more attractively priced than smaller companies right now, so think about focusing on that corner of the market when buying. If the insiders are right, the market is just pausing to catch its breath, and you won't want to miss out when it gets back on track.