Academic journal article Quarterly Journal of Finance and Accounting

Profitability of Insider Trades in Extremely Volatile Markets: Evidence from the Stock Market Crash and Recovery of 2000-2003

Academic journal article Quarterly Journal of Finance and Accounting

Profitability of Insider Trades in Extremely Volatile Markets: Evidence from the Stock Market Crash and Recovery of 2000-2003

Article excerpt

Introduction

The purpose of this paper is to examine the information content of reported corporate insider trades during the stock market crash of 2000-2002 and subsequent recovery in 2003. Insiders are known to be contrarian investors. [See Seyhun (1992), Rozeff and Zaman (1998), and Lakonishok and Lee, (2001).] But are insider trades motivated by useful inside information, or are they simply triggered by scaled price ratios (price-earnings or book-to-market ratios)? Manne (1966) and Carlton and Fischel (1983) argue that trading by corporate insiders fosters market efficiency by revealing insiders' private information about future prospects of their firms. There seems to be general disagreement in the empirical literature on the question of whether insider trades truly reveal managerial private information, or whether they simply reflect contrarian trading behavior by corporate insiders. Extremely volatile market conditions present an ideal experimental setting for examining this issue. If stock market investors were truly irrationally exuberant in the late 1990s and then became irrationally pessimistic during the big crash of 2000-2002, then contrarian trading behavior would clearly be profitable. Insiders, however, also could earn excess return by exploiting their superior knowledge about the future prospects of their firms, assuming that such private information had not already been incorporated in the stock prices.

To explore further, let us consider a hypothetical stock that has experienced significant price increase over some past time period. Suppose that this stock now commands a high price-to-earnings multiple (P/E) and a low book-to-market-equity (BE/ME) ratio. If insiders are pure contrarians, then under these conditions there should be more insider selling than buying in the stock, to the extent that is permitted by law. If insider trades are based upon their private information about future prospects of the firm, however, then their trades may or may not be contrarian in nature. If future prospects are still good, then insiders may purchase more of the stock even though the stock has experienced significant price increase and now has high P/E and low BE/ME ratios. If, on the other hand, future prospects are not good (or if all the good news have been priced into the stock already), then there may be net insider selling in the stock. Thus, trading by insiders that is based on private information may or may not be contrarian in nature.

There is extensive evidence in the literature that insider trading generates abnormal returns. [See Jaffe (1974), Givoly and Pahnon (1985), Seyhun (1986 and 1992), Lin and Howe (1990), and Rozeff and Zaman (1998), among others.] The difficulty in disentangling the two possible sources of insider trading profits (contrarian trading versus superior information) is that these are not mutually exclusive propositions. One way to distinguish the two is to jointly examine the incremental explanatory power of insider trading variables and contrarian trading indicators (such as past stock returns and BE/ME ratios). Irrational trading behavior by market investors in extremely volatile markets (as were observed between 1999 and 2003) can magnify the profitability of both informed trading and routine contrarian trading. Because both sources of profits are likely to be magnified, such market conditions present an ideal experimental setting for examining the sources of gains from insider trading.

The empirical evidence in the literature on the sources of long-horizon insider trading profits is mixed. Several papers examine the ability of corporate insiders to time the market successfully in their personal trades and with their corporate decisions. Several of these papers conclude that insider trading and financing decisions are significantly correlated with subsequent stock returns. [For a partial list of such studies see Seyhun (1990), Ritter (1991), Loughran and Ritter (1995), Spiess and Affleck-Graves (1995), Baker and Wurgler (2000), Kahle (2000), and Clarke, Dunbar, and Kahle (2001). …

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