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Posted 11/1/2001
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The Speculator
The market signals are turning yellow
Historically, a bad month followed by a good one – like our September and October – produces the worst returns. We're keeping our portfolio on a short leash, though we're still bulls for our biotech.
By Victor Niederhoffer and Laurel Kenner
Before dashing a man to the ground, the elephant first lifts him up into the air.
-- Indian proverb
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Signaling, the conscious or unconscious conveyance of wordless information, pervades life and markets. The gazelle jumps high to impress upon the lion the advisability of finding an easier prey. The consumer-products company offers a long warranty. A glance signals to an attractive other that advances would be welcome. And then there is the Speculator column that leads without a promise of profit-making ideas in individual stocks.
After declining 8% in September, the market looks to be on the way to an October gain as we write. As shown in the table below, a down month followed by a rise has been the least bullish of signals for the succeeding month.
S&P 500 Futures monthly patterns
| Previous month | Current month | Mean
change next month |
Standard deviation | Up in
next month XX% of the time |
| Up | Up | 0.7% | 3.8% | 60% |
| Up | Down | 2.1% | 4.5% | 78% |
| Down | Up | 0.1% | 3.2% | 53% |
| Down | Down | 1.4% | 6.2% | 67% |
(We would be pleased to send a spreadsheet of the monthly results for the past 10 years to those who didn't receive it last week. Write to dciocca@bloomberg.net.)
The numbers in themselves are not cause for undue bearishness. More important is what Soviet chess grandmaster Alexander Kotov referred to as "dizziness due to success." The prospect of imminent victory lowers vigilance and encourages complacency and over-confidence, writes reader Nigel Davies, himself an international master, trader and author of numerous bestsellers on chess. The rise from the Sept. 21 bottom of some 20% in Germany and 10% in most U.S. and Asian markets makes us somewhat wary that complacency is setting in, particularly as seven weeks have passed since the World Trade Center attack without a deadly attack on the same scale.
In short, we don't feel the season is propitious for fielding new stock picks. Not only that, we'll be reducing our holdings in the low-priced portfolio we recommended on Sept. 27. The stocks are up 15% on average, and that is good enough for us, at least during the current market environment.
Reading the signals
Separating the good signals from the bad -- the ambiguous or deceptive -- is no small problem in interpreting insider buying and selling. Serendipitously, one of our readers and mentors has a chapter on signaling in his forthcoming book, "Paving Wall Street: Experimental Economics and the Quest for the Perfect Market," coming out in December. He is Ross Miller, a former risk management consultant and risk guru at General Electric (GE, news, msgs). Miller's thesis adviser at Harvard was Mike Spence, who won a Nobel Prize in economics last month for his work in the field.
Because proper signals are never known in advance, signaling discovery, like price discovery, is a natural part of the market, Miller says. "We're all trying to find out, and we're all guinea pigs in the experiment." Unfortunately, it's relatively easier to discover the wrong signals -- just watch the traders who don't make it.
Ross is mostly in cash right now, but he has Millennium Pharmaceuticals (MLNM, news, msgs) on his list of potential buys if the market declines more, as he expects it will. "Reaching a point where one would have to be a fool to buy equities would be what I would consider to be a good entry point," he told us.
Some readers offered refinements on reading the signals of insider buying. "There can be many false positives," wrote Harvey Bloomfield. "Companies frequently lend executives money to purchase company stock with loans that can, and may, be ultimately totally forgiven. I look for insiders who have been correct on the sell side in the past and are now buying again. This has been an accurate indicator. If you just follow purchases you can get burned badly."
Reader Harry Starn prefers stocks where the chief executives, chief financial officers or chairmen have been buying. "I have found that not all inside buying is created equal," he wrote. One of the stocks he brought to our attention is Lexicon Genetics (LEXG, news, msgs), which is not so thinly traded as to preclude our mentioning it.
Robert Brearley, a U.K. scientist, sent a list of biotech companies where insiders bought shares after the expiration of the "lock-up period" during which officers and directors have agreed not to sell their holdings. The purpose of an initial public offering is twofold: to make the owners wealthy, or to raise money for the company, and usually both. Insiders, when they buy the stock after the IPO, signal that it's more for the latter reason. Brearley's list included four we mentioned in our previous two columns -- 3-Dimensional Pharmaceuticals, Durect (DRRX, news, msgs), Dyax Corp. (DYAX, news, msgs) and Medicines Co. (MDCO, news, msgs). He also had some new names: Curon Medical (CURN, news, msgs), Eden Bioscience (EDEN, news, msgs), Kosan Biosciences (KOSN, news, msgs) and Pharsight (PHST, news, msgs).
Unfortunately, the odds seem stacked against the stock investor right now. Like most things in life, the market likes to accomplish its goals with the least amount of effort. One way natural life achieves this is to signal to the prey that danger is in the air. Thus, the caterpillar is often colored like a wasp to deter attack.
When the low-priced stocks and the general market environment start looking again like they'll sting, we will regain our extreme bullishness and signal it here.
A win we can't explain
As far as we can tell after doing some calculations, the superior performance of low-priced stocks this year on average is the highest in history. In January of this year, the bottom fifth of all companies, classified by price, rose an average of 29%, versus 9% for the average stock. Similarly, in October of this year, the average low-priced stock went up 18%, versus 10% for the average stock. Year to date, the lowest-priced fifth of all stocks went up an average of 28%, while the highest-priced fifth went down 21%. The greatest divergence in the previous 10 years was 11% in 1991.
We have no explanation for these results and must therefore attribute them mainly to luck. Having participated in this aggrandizement in both October and in January, when a portfolio we recommended for another online publication, Worldly Investor, went up some 100%, we think it best to reduce our holdings of the 10 recommended stocks by at least half this week. We plan to sell into strength near the close on Thursday and Friday. On all subsequent strong days, we will reduce by one-tenth, in five stages, until we are left with no holdings. We'll probably get long again in December.
We're sticking for now with the beaten-down biotech stocks we recommended in our last column, the ones that insiders had the moxie to buy even in the face of the minuscule chance that their product will be among the lucky 20 or so a year among the thousands awaiting passage through the reverse horn of plenty known as the U.S. Food and Drug Administration screening process. (No wonder that companies with competing antibiotics to Cipro are offering their products for free if the FDA will give them the nod.)
Still bulls on biotech
In response to last week's biotech article, we received hardly any diatribes. The worst was a dire warning that biotech was going to ruin the world, and why didn't we learn a bit more about it? There were no calls for us to resign, no admonitions that bullishness at this time invites disaster, few reminders that Vic lost a bundle in 1997 and should go into hiding, no pointed remarks about our never having been invited to speak at a Technical Analysts Society meeting, no stern rebuke from our editors to the effect that we should write something useful for a change rather than offer the usual collections of checkers proverbs, observations on baseball or philosophical meals for a lifetime.
The response to our biotech column was as follows:
- 188 requests for information
We're viewing the biotech portfolio as a one-year holding. However, we are inclined to hedge it by shorting biotechs with insider selling -- which, it turns out, is a fairly good signal. A random sample of 50 stocks in the Russell 2000 with insider selling over the last five years went up an average of 32% in the year after the selling, about 12 percentage points below the average for stocks with insider buying.
At the time of publication, Victor Niederhoffer and Laurel Kenner owned the following equities mentioned in this column: Dyax and The Medicines Co.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.