Insiders

For no fee at all I am prepared to offer to any wealthy person an investment program which will last a lifetime and will not only preserve the estate but greatly increase it. Like other great ideas, this one is simple:

When there is a stock-market boom, and everyone is scrambling for common stocks, take all your common stocks and sell them. Take the proceeds and buy conservative bonds. No doubt the stocks you sold will go higher. Pay no attention to this — just wait for the depression which will come sooner or later. When this depression — or panic — becomes a national catastrophe, sell out the bonds (perhaps at a loss) and buy back the stocks. No doubt the stocks will go still lower. Again pay no attention. Wait for the next boom. Continue to repeat this operation as long as you live, and you'll have the pleasure of dying rich.

Coming so soon after not only the crash of 1929 and the short, savage bear market that followed, but also after the bull market from 1933 to 1937, a skeptic could perhaps brush off Schwed's absurdly straightforward investment strategy as merely a recitation of what would have worked over his recent past experience. However, as Schwed notes later, "a glance at financial history will show there never was a generation for whom this advice would not have worked splendidly." This is as true in the markets of the 1980s and 1990s as it was in the markets of the 1930s and 1940s.

Writing in his book, The Vital Few Vs. The Trivial Many, George Muzea, president of Muzea Insider Consulting Services, Llc, recalls the story of a conversation between a successful businessperson and his accountant one day during the bull market of the 1980s. The successful businessperson was gazing out of his office window and asked his accountant, "Has business ever been so good?" The accountant replied, "No, business is better than ever." "Good," the successful businessperson replied. "Call my broker and sell all of my stocks."

Contrarianism such as that suggested by Fred Schwed and the businessperson in Muzea's anecdote is far easier recommended and spoken of than actually performed by real investors with real money invested in real time. The psychology of bull and bear markets, the pull of greed and fear, are especially strong emotions. When those emotions are combined with the pressure of potentially making or losing significant sums of money, few can weather this storm of conflicting impulses in order to follow one of the oldest dicta in investing: "Control your emotions. Buy low and sell high." In bull markets this adage is typically transformed into a momentum-driven "buy high and sell higher" philosophy, and even when the bull market has ended, the social psychology that accompanies it can be particularly stubborn and long-lasting. As Schwed noted of the "buy low and sell high" approach to investing more than 50 years ago:

. . . It distresses me to report that I have never enjoyed the social acquaintance of anyone who managed to do it. It looks as easy as rolling off a log, but it isn't. The chief difficulties, of course, are psychological. It requires buying bonds when bonds are generally unpopular, and buying stocks when stocks are universally detested.

But while it is true that contrarianism in investing, when done properly, can be a hugely successful way to profit in the marketplace, the question remains: To whose opinions should investors be contrary?

THE TRIVIAL MANY

George Muzea discovered the answer to this question while trying to unlock the secret to his own success as a stockbroker in the late 1960s. After making the decision to use charts as a way of screening out the brokerage firm's list of "stocks to sell to clients" — stocks Muzea says always seemed to be in the "new lows" list at the bottom of every bear market — Muzea realized that another major decision would be necessary in order to turn a comfortable career as a stockbroker into a truly winning one for himself and his clients:

Since I had inferred that success in the stock market required a certain type of reasoning that was impossible for the human mind to utilize, I had to admit I was a loser in the stock market and it would logically follow that everyone who followed my advice would also be a loser. I also knew that there were experts out there who couldn't or wouldn't admit they were losers too. These experts and the millions of investors they influenced were the Trivial Many. It was this group that I would bet against in the future. After all, they were losers and didn't know it.

Muzea's insight was based on the thinking of 19th-century Italian economist Vilfredo Pareto, who discovered that 80% of the wealth in Rome was controlled by 20% of the population. This 80/20 ratio has over time become a standard conception in many aspects of business and in society at large. More important than the actual number, however, is the notion that most of the productivity in any given situation will be derived from a relatively smaller proportion of the available producers. Extrapolated to the stock market, it echoes the adage that most of the big money made in the markets is made by a relatively small group of investors. William Eckhardt, an accomplished mathematician and, with Richard Dennis, founder of the Turtle Trading trend-following methodology, noted this phenomenon in a conversation with Jack Schwager more than 10 years ago:

If a betting game among a certain number of participants is played long enough, eventually one player will have all the money. If there is any skill involved, it will accelerate the process of concentrating all the stakes in a few hands. Something like this happens in the market. There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you'll gravitate toward the majority and inevitably lose.

The mainstream financial media, the average stockbroker, the average investor . . . all are a part of the Trivial Many whom contrarians have been fading (that is, betting against) since time immemorial. Whether it is through technical indicators like put/call ratios, advisory sentiment, or the VIX (volatility index), contrarians have used a variety of methods to gauge the sentiment of what has been referred to unkindly as "dumb money." One of the greatest investors of all times, Warren Buffett, though not always considered a contrarian, is nevertheless famous for making one of the contrarians' favorite quotes: "If you are at a poker game and you don't know who the sucker is, then it is you."

But as Muzea points out, it is not enough to know whom not to follow. Certainly, at some points — such as during major stretches of the late 1990s or, more recently, during the rally of the early summer of 2003 — the herd is in full stampede mode and fighting that wave of galloping hooves can be hazardous to one's financial and psychological health. Another market adage reminds that the markets can be irrational for far longer than most investors and traders can remain solvent. So there must be something more to following a winning contrarian strategy than just knowing whose opinions to avoid. An investor or trader also needs to know whom he or she should follow.

THE VITAL FEW

The key to this discovery came slowly, and Muzea found it largely in the course of his work as a stockbroker. Time and time again in The Vital Few Vs. The Trivial Many he recounts instances early on in his career when he witnessed various insiders — corporate CEOs, CFOs, and other major officers — taking advantage of their proximity to and fundamental knowledge of their companies. Muzea points out that he is not talking about illegal "insider trading" per se. Most of the sort of information Muzea uncovers with regard to insider behavior is publicly available in magazines like Barron's, which publishes a weekly table of "Insider Transactions" and a separate table devoted specifically to 144 filings for the sale of preferred securities. Such information is also available online at popular websites such as Yahoo! Finance and CBS MarketWatch. Paid or subscription-based websites such as Vickers Stock Research (www.vickers-stock.com) provide a wealth of insider trading behavior that investors and traders can use. Nevertheless, Muzea acknowledges that some of what he saw as a broker made him believe that, when it does come to illegal insider trading, "the SEC catches only the big fish, the tip of the iceberg, while every day violations occur that the SEC has neither the manpower nor the will to prosecute."

However, it is still not enough to merely follow the buying and selling of corporate insiders. A successful trader or investor must know when to follow the insiders. Here, Muzea points to the powerful role played by divergences between typical and atypical insider behavior:

One thing all insiders do understand . . . is the intrinsic value of their own company's stock. Intrinsic value is the price at which a company could be liquidated or sold to an interested buyer. When their company's stock approaches or drops below intrinsic value, insiders buy. The lower it goes, the more they buy. On the other hand, when stocks rise above their perception of intrinsic value, insiders sell. The higher it goes, the more they sell.

Muzea realized that divergences from this normal pattern of insider buying and selling were more important than the actual buying and selling. For example, if instead of buying his or her company's stock as its price declined, a major corporate officer was selling the stock — getting back less and less with each sale — then that behavior would be a divergence from the normal pattern of insider market behavior, and could serve as a market signal to other traders and investors to take action. Similarly, if instead of selling into price strength a major corporate officer was noted buying more shares of his or her company's stock — paying higher and higher prices each time — then that would provide a different sort of signal.

RIDING WITH THE INSIDERS

When it comes to actually taking positions in the market based on the buying and selling behavior of insiders, Muzea himself uses a formulation he refers to as the Magic T. The Magic T helps him distinguish between the traditionally contrarian signals provided by sentiment, advisory newsletters and the media, and divergences in the normal buying and selling behavior of corporate insiders. The Magic T approach outlined in The Vital Few Vs. The Trivial Many is easy to follow (although that hasn't stopped a number of readers from cajoling Muzea into launching a service through which he provides subscribers with his own weekly Magic T assessment of the markets) and is equally applicable to individual stock investors and traders, as well as to those who prefer to buy and sell sectors or the market as a whole by way of exchange-traded funds.

Moreover, the Magic T is no less useful for shorter-term traders such as swing traders, who prefer not to hold positions for much longer than six or seven days. In a recent telephone conversation, Muzea pointed out that a shorter-term trader could, for example, get a Magic T buy signal, set up a core long position of 10X shares in a stock that is likely to take advantage of the buying opportunity, and then create "trading" positions of 5X or fewer shares with buys on dips and sells on rallies. "Whipsaws are the bane of traders everywhere," Muzea observed. "The Magic T can help traders avoid whipsaws by showing them the direction of the market." Because insiders are not market timers, he added, they will tend to be early. Those skilled in technical analysis, for example, will be able to make the most of the early signals any sound analysis of insider buying and selling may provide.

The life of a contrarian ain't no crystal stair, as the verse goes. Most of the time, as Muzea recalled, everyone you know and everything you hear will disagree with you: "You've got to take the insults. Be patient and strong enough to ride it out." But the rewards for the successful contrarian can be sizable indeed. Muzea, whose book is filled with colorful personal examples, anecdotes, and war stories, notes the careers of people like Aristotle Onassis, the legendary shipping tycoon, or the great money manager George Soros. These men built their massive fortunes in large part by zigging while the rest of the world zagged. According to Muzea, "It is impossible for the masses to be right at major turning points" in the markets. "The only way to accumulate wealth is to go against the crowd."

David Penn may be reached at DPenn@Traders.com.

SUGGESTED READING

Hadady, R. Earl [2000]. Contrary Opinion: Using Sentiment To Profit In The Futures Markets, John Wiley & Sons.

Muzea, George [2003]. The Vital Few Vs. The Trivial Many, Seven Locks Press.

Schwager, Jack D [1995]. New Market Wizards, John Wiley & Sons.

Schwed Jr., Fred [1995]. Where Are The Customers' Yachts? John Wiley & Sons.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.