Massive Insider Trading? – March 2, 2010

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Also, LET ME BE CLEAR…nothing in my daily newsletter should be construed as investment advice (unless you’re searching for a contrarian indicator).




Now, on to what I read…




1. Markets

The Dow gained 78.53 points.  There was positive news about manufacturing and consumer spending as well as optimism about the ending of the Greek tragedy.




The Russell 2000 (small caps) gained 2.2% on speculation of increased M&A activity.  (Small firms are more likely to be acquired.)




The dollar gained .5%.  Oil closed at $78.70.




The WSJ reports that oil has a 60% correlation with the Dow and this is 8X the five year average.  Agricultural commodities have a 33% correlation with the Dow and this is 2.3X the historic average.




The WSJ wrote that it might be time to reverse the Greek bet.  In other words, if the EU bails out Greece, the credit default swaps will decrease in value.  I mentioned a week or two ago that no one really expects Greece to default on this go around.  Personally, I think speculating on credit default swaps of Greece is crazy – but I’m just a poor public school teacher – so if you listen to me, you’re a moron.




2. Economy

The Institute for Supply Management index was 56.5 in February (down from 58.4 in January).  A number > 50 represents expansion (and this was the seventh consecutive month above 50).  Their employment index increased from 53.3 to 56.1.  This was the third consecutive increase and the highest reading in five years.




The personal consumption expenditures price index increased .2% in January (vs December) and was 2.1% higher YOY.




The savings rate was 3.3% in January.  This is down from 4.2% in January and the lowest since October 2008 (2.9%).  We’re Americans.  We’re already saving less.




Global chip sales increased .3% in January.  They are 47% higher than last January!




3. Financials

Sticks and stones may break our bones. Goldman listed “adverse publicity” to their laundry list of risk factors.  They say that this publicity could hurt morale.  Personally, you could write all the bad things about me that you want if I get a decent size bonus.  But I’m used to being insulted.  I’m married.




The WSJ reported that seven of the largest global investment banks reduced their compensation relative to revenue.  This seems pretty silly.  Revenues in 2008 were very low – so the ratio numbers were misleadingly high.




4. Government

A single Senator, Jim Bunning (R, KY) blocked a $10 billion bill that would have extended unemployment benefits and other programs.  As a result, 100,000 people saw their benefits expire on Monday, doctors saw a 21% reduction in payments for treating Medicare patients and 41 transportation projects came to a halt.  There is another bill in the works that will be retroactive (to get these people their benefits) although some people say that the unemployed people will have to reapply (and that will cause delays).  Bunning said that he is not opposed to extending the benefits, but he wants to know how we will pay for this.




Quitter! Donald Kohn, Vice-Chairman of the Fed announced his retirement.  He has only worked at the Fed for 40 years!  There is speculation as to who will replace him.  Some think it will be Daniel Tarullo, Obama’s appointee who is focusing on improving regulation.




5. Notes from the Evil Side

Boo hoo hoo…we’re capitalist pigs. Toyota’s president blamed their problems on a focus on profit and market share.  The focus on profit led to excessive cost cutting.  Sorry Mr. T, but you can focus on profits and market share and still do business in a moral way.




The Madoff bankruptcy judge ruled that investors who had taken out more than they put in (to Madoff’s funds) were “net winners” and should not share in any of the recovery.  Approximately half of the investors were “net winners.”  The net winners argue that they were relying on their account statement and were equally injured.




I hope all of my friends at GS appreciate that I put the GS story in the financials category and not here.  Part of the problem is that if I put it here (in the Evil Side category), I would have proven them right about the adverse publicity.  Wait a second, this means that these guys were right again.  They’re freakin’ amazing!




6. Really Important Story: CEO Hedging

Business Week reported on an academic study about CEO hedging (as well as directors and executives).  While CEOs still own the shares after entering these hedging transactions, you have to dig through the footnotes to understand that the CEO no longer has downside risk.




The BW article focused on two primary ways for an executive to hedge:

1. prepaid variable forward contract – executive receives cash advance of up to 85% for shares that he will eventually sell to bank.  Executive collects dividends and still is the technical owner.

2. collars – option strategies in which you give up most of your upside as compensation for getting rid of your downside.




The academic study examined 2,010 hedging transactions by 1,181 executives at 911 firms between 1996 and 2006.  On average stocks had increased 17% – 31% prior to the executive’s hedge.  Shares in companies where the CEOs, directors and other top executives had hedged using a variable forward sale underperformed the market by 16.2%.  The underperformance was 25% for collars.




Realize that this is still going on. In 2009, there were 107 times when executives hedged.  The information on the hedge is contained in Form 4. They are not listed in the tables (that are the focus of Form 4).  Companies must disclose an exercise price and the “dollar value locked in.”




So here’s the issue…should CEOs be allowed to hedge?  Without question they should.  But if this study is correct, it’s hard for me to believe that we are not seeing systemic insider trading.  In other words, when insiders are consistently right (especially with the large excess returns), how can I believe that this is random?  They have to be using material, nonpublic information.  And don’t forget…insiders profited on the downside during a ten year period in which the stock market was up over 100%.  Pretty impressive?




I have not read the academic paper yet.  I just downloaded it and skimmed it.  It looks very interesting.  I’ll try to mention more about it in the next month when I read it.  But, here’s a link to it in case you want to read it:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1364810




The paper, “Insiders’ Use of Hedging Instruments: An Empirical Examination,” was written by J. Carr Bettis (Arizona State), John M. Bizjak (Portland State) and Swaminathan L. Kalpathy (SMU).




7. Random

My big break!  In the past, I’ve thought about appearing on Jeopardy.  But Jenny explained to me that I didn’t know anything except a little bit about finance and that there were likely to be some other categories on the show.  That was probably good advice.  But finally, there’s a show that I think I can dominate…”The Marriage Ref.”  It’s time for America to stand up for me and see how misunderstood I am.  I’m pretty confident that America will tell Jenny that she’s wrong to be offended when I introduce her as “my first wife.”




Hotel rates fell 14% last year according to Hotels.com. The average hotel price was cheaper in 2009 than in 2004 (when the index began).  Jenny suggested that this meant we could travel more.  I had to break it to her that LaQuinta’s prices hadn’t dropped that much.
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