The TRUTH of insider trading a la Joshua Brown

I liked Joshua Brown’s Insider Buying/Selling: The Collected Wisdom of a Thousand Heartbreaks (see it also posted at the CSMonitor with the toned-down title: ‘Debunking Myths…’)

There has been a lot of talk during this rally that the insiders — in the aggregate — were selling stock all the way.  The Pragmatic Capitalist has done a good job following this trend of insider selling.  In Brown’s piece, he lists 10 things he learned about insider trading — all gross generalizations, but interesting nonetheless.

My favorites?

2. Technology executives would rather be locked in a dark basement, listening to Billy Joel’s Uptown Girl on an endless loop, than make an open market purchase of their own stock.

And

9.  I avoid the stocks of executives who go on TV and speak promotionally while dumping larger-than-normal blocks of their own stock.  This is because I’m street smart and Street smart.  It’s not always the right thing to do, but I sure feel better.

As I’ve written repeatedly here and in my book due out in June, insider buying/selling is more useful when trying to size up individual stocks than the market in general. 

Amen, Josh.

Crowdsourcing investments: it’s all about chosing the ‘right crowd’

We’ve spoken a lot about piggyback investing (mimicking the moves of top fund managers) and crowdsourcing ideas (using crowd sentiment to generate trading ideas) as two ‘new ways’ investors can devise profitable strategies.  The Internet is producing tons of information – the tradestream – that investors can plug into to get at this type of data.

But investors keep asking me, “Well, who do we follow?”  And they’re right – the Web continues to provide more and more insight into the daily trading activities of some of the brightest performers but with this onslaught of informational smog, we’re still left with the decision of who to track, who to follow, which crowd to source.  In Surowiecki’s book, in fact, he delves into the difference between smart crowds and not-so-smart crowds. 

TrimTab is one of the leading providers of capital flow information around which it creates trading strategies.  Last week the firm published a whitepaper (.pdf) outlining a contrarian ETF strategy that makes use of this aggregate data and actually bets against the dumb-money — in this case, the average retail investor.

In “Using Equity ETF Flows as a Contrary Leading Indicator” (.pdf), TrimTabs found the following:

  • Monthly  equity  ETF  flows  (as  a  percentage  of  assets)  and  the  returns  of  the  S&P  500  one  month  later  are negatively correlated to the tune of 21.4%. 
  • The  negative  correlation  rises  to  45.6%  for  a  two-month  period,  and  to  52.4%  for  a  three-month  period.  

With this in hand, the research firm created a system that goes long the S&P when money is flowing out of ETFs and sells it when money is moving in.  The results are amazing:

trimtabsperformance

The researchers suspect 2 reasons behind this performance:

  1. they believe that ETFs are typically really liquid and used primarily by retail investors whom TrimTabs believes are the least-well informed investors out there. Or better put, the ETF liquidity “allows investors to make poor decisions any time of day.” Or, as MarketWatch put it, “Simply put, ETF investors are impressively wrong in both directions.”
  2. hedge funds trade ETFs when liquidity dries up in individual stocks. 

Whether this works or not or is just backtested data (it works until it doesn’t), I don’t  know.  But it does drive home the importance of following the ‘right’ crowd or the right guru.  Otherwise, we are just part of the investing noise, not rising above it.

Looking at Magic Formula returns, Morningstar gets all apologetic over industry performance

Screening 2.0 and beyond

Readers of this site have learned a bit about Screening 2.0 — the ability to use Internet tools (many of them, free) to recreate portfolios that conform to the investment criteria of history’s best investors.

Validea’s John Reese has done much of the research legwork on the subject and has produced a premium product to help investors create Peter Lynch, Ken Fisher, and Ben Graham portfolios (among others).

The magic of  Greenblatt’s Magic Formulamagictrick

One source I mention frequently is Joel Greenblatt’s Magic Formula.  Greenblatt wrote about his investing magic in The Little Book that Beats the Market.  He also provides investors with a free website to screen for the top ranking stocks that fit his criteria at magicformulainvesting.com.

Morningstar takes a look at Magic Formula returns in a recent piece.  Here’s what they come up with:

We see that the formula posted approximately a 19.9% annualized return from the beginning of 1988 through Sept. 30, 2009. Over that time, the S&P 500 Index returned 9.4% annualized.

Not too shabby.

But as a frequent shill for the mutual fund industry, Morningstar feels the need to compare this market-trumping return to top performing mutual funds.  And that’s when things take an interesting turn:  The article’s author, John Coumarianos, sounds surprisingly introspective in his (near) critique of active fund management.

The market isn’t efficient, as the indexers say, but its inefficiencies are apparently not easily exploitable for some of the finest pros either–at least given how many of them currently go about investing, trying earnestly to predict future profits and discounting them back to the present. Perhaps managers outthink themselves or have too much confidence in their predictive abilities instead of relying on past results.

Why funds may perform so badly as a class

The author also cites the mutual fund structure, size, and the legacy nature of a fund portfolio — making it so easy for investors to buy and sell an already outdated model — as an impediment.  Does this mean that portfolio mirroring a la kaChing and Covestor (where investors sync their brokerage accounts up to a professional investor’s portfolio model) has another leg up on the industry?  The separately managed account model (SMA) which institutionalizes this mirroring process does have its benefits, including better tax efficiency (all stocks are held in investor’s name and cost basis is individualized) and transparency (stocks in the portfolio are held in brokerage account).

Investors and Google Buzz: a threat to StockTwits?

With much fanfare yesterday (they even arranged a blizzard for much of the googlebuzzU.S.), Google announced its social media offering, Google Buzz (see video below).

What is Google Buzz

So, what is Buzz?  I like Matthew Ingram’s description on GigaOm of the Google Buzz service:

Google’s new service looks and feels a lot like many other social media tools and networks. The primary input is a box for status updates, just like Twitter and Facebook. You can use @ replies, just like Twitter, and you can share photos and other media content easily (there’s even a photo gallery function like Facebook’s). If you’re mobile, you can give Google Buzz your current location and get comments about that location, just like Foursquare and Gowalla and Yelp. But the single biggest difference between Google Buzz and all of these other services is that Buzz is tied to email.

I think what’s interesting here is that it looks like a take on Twitter and Facebook that will allow more intellectual collaboration.  And by that, I mean an ongoing, multimedia, conversation centered around specific content.

How Investors use Social Media

Beyond the back-and-forth whether Google Buzz is a big hit or flop, I began thinking how investors could use this service. When I do this (it’s a messy process, sorry), I tend to use the New Rules of Investing framework.  Investors using social media tend to piggyback gurus (cloning super investors’ portfolios a la AlphaClone), crowdsource ideas (like Piqqem), participate in expert communities (like Covestor and kaChing), and use new technologies to better screen for investments.

StockTwits: What it does

We all know of the initial successes of StockTwits — it’s a good service, run by competent, thoughtful people and has created a pretty loyal (can I say, rabid?) following of users.  Built on Twitter, StockTwits layers in functionality specific to traders and investors (they’ve even skinned their own Twitter software client).

StockTwits users are plugging into what I call (in my upcoming book) the Tradestream: online investors’ publicly available trading logs, complete with their thoughts and theses behind the trades and market conditions.  These are short thoughts, 140 characters or less in length, and typically stand alone.  It’s hard for someone participating in a conversation — let alone, someone who is merely a spectator of one — to group together thoughts into a cohesive conversation (think of how Gmail deals with emails/chats as part of a discussion).

How Google Buzz improves on Twitter/StockTwits

Google Buzz changes this.  Buzz groups thoughts, however errant or short, together into an ongoing discussion.  For example, assume someone posted their thesis on whether Google (GOOG) is a long or short candidate.  In yesterday’s pre-buzz world, an investors would use StockTwits’ Twitter client and post, “Thinking Google’s a long here.  Any thoughts?”.  This would be followed by a string of responses over the next few minutes and trickling in over the next couple of hours.  To view this unfurling chat, users could check the StockTwits Google Page online or access this data through a Twitter client.

But, and here’s the thing, there is nothing cohesive pulling these scattered thoughts into a conversation to help me make a decision regarding GOOG.  Of course, I can scan the output — the tradestream — and piece it together myself.  The power of the conversation is lost on Twitter and instead turns the stock research process into an incessant deluge of sound bites. That process of vetting ideas is especially important to investors.  This is not a ding on StockTwits as much as its the product of how Twitter works.

Google Buzz changes this.  And more, it inserts the tradestream into my email client, where I’m already spending my time — not a game changer, it just enables me to close one more window.

Is this something StockTwits can address?  Surely.  Howard Lindzon and team understand what investors/traders are looking for and are rolling out tons of functionality (have you seen StockTwits TV?  Loving it, actually).  It’s this focus on the investor/trader/analyst that will continue to trump Google’s more general efforts in this space.

Thoughts?

Recommendation for Tradestreaming from Cliff Wachtel, Chief Analyst, Ava FX

As part of our service to our readers we occasionally point out books that are uniquely worthwhile. Here’s one, Zack Miller’s Tradestream Your Way To Profits.

Finally, here’s a one-stop guide to the Internet for investors and traders.

This is one of the few new investment books that any serious investor or marketer of financial services truly, truly must read, likely to become the definitive guide to using financial social media to improve investment performance. I’d been looking around for something like this, and now, here it is.

All serious investors and traders realize that they need guidance, and that there is a lot of great advice on the internet, much of it for little or no cost.

Few would dispute that they’d be more profitable following the moves of proven experts.

The trick is to sift through the vast online universe to locate the best sources.

The idea is simple enough, but it took someone with deep expertise in online media, financial planning, and fund management to distill the best the Internet has to offer.

The book provides an overview of how changes in the internet, financial research, social media and online content have given us unprecedented access to some the best investment advice. It then examines 8 different strategies for using online investing resources and provides practical advice for how to implement these 8 approaches, which are:

  • Expert Bloggers: How to access the best blogs for new ideas
  • Imitate Proven Stars: How to build a portfolio made of the top picks of your chosen gurus.
  • Join Expert Communities: How to locate and use online communities to identify and monitor professional or amateur experts.
  • Online Resources For Monitoring Crowd Sentiment.
  • Screening 2.0: How to create screens suing the same parameters as the pros.
  • Tracking Insider Moves
  • Tracking Rumors
  • Non-Financial Online Resources

The summary chapter’s look at how the Internet is changing the financial services industry is a must read for those interested or working in the field.

As an analyst who covers forex, commodities and bonds in addition to equities, I only wish that there wasn’t such a heavy concentration on resources for the equities markets, though the focus is understandable given that stocks have a much more established online presence.

However, the ecosystem of online resources for these other markets is growing.

Can we look forward to a follow up volume covering these markets? — Cliff Wachtel, Chief Analyst, Ava FX

Recommendation for Tradestreaming from marketfolly

From the August 6, 2010 marketfolly review of Tradestreaming:

If you’re looking for another book on the same old topic of stockpicking, then this isn’t for you. However, if you’re searching for a new-age approach to investing that incorporates the use of copious online resources (including social media), then you’ve found the right book. Readers of Market Folly should find this work of particular interest given its focus on mimicking top hedge fund managers, a topic we cover on a daily basis…

The review ends:

Novice investor? This book is a great place for you to start. What better way to learn the ropes than by watching and mimicking the pros. Intermediate or advanced investor? There’s guaranteed to be plenty of new resources and tools for you to learn about that will highly complement your regular research regimen. There’s hundreds of different books out there that train you how to pick stocks. This book does not do that. Instead, Tradestream Your Way to Profits teaches you how to incorporate new online tools, methods of research, and investment approaches in order to construct a more profitable portfolio. — marketfolly

Read the rest of marketfolly’s Tradestreaming book review.