Style Timing with Insiders

Aggregate demand by insiders predicts time-series variation in the value premium. Insider trading forecasts the value premium because insiders sell (buy) when markets—especially growth stocks—are overvalued (undervalued). This article suggests that investors can use signals from aggregate insider behavior to adjust style tilts and exploit sentiment-induced mispricing.Aggregate insider demand forecasts time-series variation in the value premium—a high level of insider buying signals that the future value premium will be lower (growth beats value), whereas insider selling portends a higher value premium (value beats growth). For example, between 1978 and 2004, an increase of one standard deviation in aggregate insider demand measured over the previous six months forecasted a 53 bp decline (6.54 percentage points [pps] annualized) in the expected value premium in the month following publication of the insider trading data. Moreover, aggregate insider demand forecasts the value premium more effectively than either the difference in growth and value stock valuations (the “value spread”) or lag returns.Consistent with previous research, we found that aggregate insider demand also forecasts market returns. The relationship between aggregate insider demand and future market returns, however, largely results from aggregate insider demand’s forecasting growth stock returns. An increase of one standard deviation in aggregate insider demand forecasts a 76.8 bp increase in monthly growth stock returns (9.62 pps annualized) versus a 23.9 bp increase in monthly value stock returns (2.91 pps annualized). Further analysis indicated that aggregate insider demand in either value stocks or growth stocks predicts growth stock returns and the value premium. In contrast, we found no evidence of a meaningful relationship between subsequent value stock returns and lag aggregate insider demand in all stocks, value stocks, or growth stocks. Although we considered several alternatives, additional tests suggested that aggregate insider demand forecasts the value premium because insiders trade against sentiment-induced mispricing and growth stocks are more sensitive than value stocks to investor sentiment.Contrary to previous research and our own results for the primary sample period (ending in mid-2004), out-of-sample tests that incorporated the most recent market turmoil (forecasting returns from July 2004 to September 2009) revealed no evidence that aggregate insider demand measured over the previous six months forecasts market returns or the value premium. We did find some evidence, however, that short-term aggregate insider demand (measured over the previous month) forecasts the value premium. The weaker relationship between aggregate insider demand and the subsequent value premium in the out-of-sample period is fully driven by the final seven months in the out-of-sample period (returns from March 2009 to September 2009), when aggregate insider demand dropped sharply but remained high relative to historical averages. Thus, aggregate insider demand continued to forecast a reduction in the value premium during a time when the value premium recovered.