Every day, financial media is rife with headlines as to why the S&P 500 and other indexes might have gained or lost X points for the day. However, for long-term investors, the individual day-to-day changes in stock prices do not usually matter, not unless they are the result of some sudden undeniable signal that a specific business is in permanent decline.
Some may pay attention to these headlines because they are trying to time the market, finding precisely the lowest entry points and highest exit points for their investments. However, timing the market has proven to be impossible to do with any degree of accuracy, since there are too many factors affecting it.
Even if timing the market for specific stocks is not usually a good idea, though, investors can still benefit from two things: buying stocks that are trading with a margin of safety and rebalancing their portfolios for risks depending on whether the market is bullish or bearish. It is in these cases where analyzing the overall economic situation can be beneficial.
With most stocks in the red year to date and inflation worse than it has been in 40 years, value investors are now seeing more bargain opportunities than we have in years. Even
Warren Buffett (Trades, Portfolio), who was previously a net seller of stocks for the past couple of years due to a perceived lack of value opportunities, has gone on a buying spree in 2022 according to Berkshire Hathaway’s (BRK.A)(BRK.B) filings with the Securities and Exchange Commission.
Even with value opportunities on the rise, wary investors are still wondering when we can expect the market to hit a bottom and when we can expect it to recover. There is no definitive answer to these questions, especially for specific stocks, but there are a couple of leading indicators that have historically tended to indicate a market turnaround is on the horizon: namely, small-cap stock prices and insider buying trends.
Small-cap stocks
Since small-cap stocks are more sensitive to the real economic situation than large caps, they tend to see funds yanked faster during a recession and begin their recovery sooner. Large-cap stocks are driven more by investor sentiment, so investors tend to be more willing to remain invested even during periods of economic trouble.
For example, the Russell 2000 has fallen as much as 32% from recent highs, compared with a 23% drop in the S&P 500. The Russell 2000 peaked at the beginning of November 2021, while the S&P 500 peaked at the end of December.
“You watch small-cap flows to see how people are betting on a recession, and I would naturally assume small caps to be hurt the worst if people thought there was going to be one,” Eric Balchunas, an exchange-traded fund analyst for Bloomberg Intelligence, said.
Another Bloomberg Intelligence analyst, Michael Casper, observed that the Russell 2000 tends to hit a bottom before a recession is over and outperforms the S&P 500 on the rebound. “It does take some time to recover those prior highs, but usually as sentiment recovers, small caps are the first things to bounce back,” Casper said.
It is not just their sensitivity to economic troubles that make small caps good leading indicators. These companies also tend to be much more focused on the domestic market compared to large caps that have a high amount of international sales. Small caps also tend to have higher leverage, more fixed-rate debt and shorter maturities, causing a higher default risk. These factors all provide signs of economic conditions that large caps often do not display.
Insider trends
Perhaps an easier-to-observe indicator of whether or not the stock market has hit a bottom is whether or not insiders have gone on a buying binge yet.
Since insiders are closely involved with both their company’s day-to-day operations and the overall market conditions affecting business, they are in more of an ideal position than most investors to know when business is suffering or taking a turn for the better.
GuruFocus’ Insider Trends compares the ratio of insider buying to insider selling among S&P 500 stocks to the price of the S&P 500 ETF Trust (
SPY, Financial). Historically, a significant spike in insider buying has correlated with the index hitting or nearing a bottom, as shown in the below chart:
The Insider Trends page also breaks down the insider buy-sell ratios for the different sectors of the S&P 500.
Takeaway
Investing is tough, especially during a bear market. While trying to time the market has proven an unreliable long-term strategy for most investors, it still helps to remain informed about broader market conditions and look for indications that things might be about to get better or worse so that we can strategize for the future.
Two indicators that can help us identify when the stock market is close to a bottom are small-cap fund outflows and spikes in insider buy-sell ratios. Keeping an eye on these could help avoid false positive signals when the S&P 500 gains a couple percentage points for the day during a bear market.
