research@hec - Issue#4 - (Page III)

The Dog That Did Not Bark In ‘Silver Blaze’³, Sherlock Holmes tells a Scotland Yard detective that he should focus his attention on a curious incident during the night of the crime: the dog did not bark. Sir Arthur Conan Doyle's short story demonstrates that sometimes there is more to be learned from the absence of a phenomenon than from its presence. Similarly, an absence of insider trading could explain sudden drops in stock prices, when there's no apparent reason for such stock market reactions. So, in an environment where information is often seen as a valuable asset, understanding the behaviour of those who have most of the information (i.e. the insiders), could prove invaluable in predicting, and even anticipating, stock market crashes. How can insider trading¹ patterns be used to anticipate large movements in stock market prices? Jacques Olivier uses his ‘dog that did not bark’ theory to explain the link between an absence of insider trading and stock market crashes. Based on an interview with Jacques Olivier and his article ‘The Dog That Did Not Bark: Insider Trading and Crashes’ (to be published in the Journal of Finance in October 2008), co-written with José M. Marin². M USING INSIDER TRADING TO PREDICT MOVEMENTS IN STOCK MARKET PRICES Existing literature on insider trading recognizes the informational content of insider acquisitions (an individual who adapts their investment strategy to the behaviour of insiders acquiring stock will earn abnormally high returns on their portfolio), but doesn't recognize that sales of stock contain valuable information. In other words, research undertaken thus far has failed to demonstrate that information released by insiders can help anticipate a drop in stock prices. But, by studying the relationship between the sale of stock by insiders and price movements, Jacques Olivier and José M. Marin demonstrate that it is indeed possible to anticipate a crash by observing insider sales. This relationship only becomes more complex when stock prices rise or stock is bought. EXPLAINING CRASHES BY OBSERVING INSIDER BEHAVIOUR Insider stock sales often reach a peak several months before a large drop in their price, but sales drop prior to a crash. There are three possible reasons for this phenomenon: • The effect of earning announcements: most of the crashes occur following an announcement by a company that it has failed to meet earnings expectations and most companies prohibit insiders from trading prior to an earning announcement. It is therefore quite logical that insider activity should be low at the time of a crash. • The desire to escape scrutiny from the SEC4: the agency responsible for regulating the U.S. stock market is particularly vigilant about investigating any insider trading that takes place near the date at which the price movement occurred. Insiders therefore tend to limit their transactions just before a crash to avoid arousing the suspicions of the SEC. • The ‘dog that did not bark’ theory: investors are informed when insiders sell their stock, and this leads to a partial downward adjustment of prices. But if the insiders have already sold off any stock they could sell, and then stop trading for a long period, investors can only infer that insiders are in possession of bad news, but not how bad the news CAREER Jacques Olivier is Associate Professor of Finance and Economics at HEC Paris and Program Director of the MS International Finance HEC. He graduated from ESSEC (French business school and grande école) in 1991 and holds a PhD from the University of Pennsylvania. His research interests are in the fields of capital markets, growth theory, and international trade. Some of his most recent work deals with stock market crashes and insider trading (in collaboration with José M. Marin), mutual fund managers' incentives (in collaboration with Anthony Tay) and the effects of globalization on culture (in collaboration with Mathias Thoenig and Thierry Verdier). September-October 2008 • research@hec III http://www.hec.edu/hec/eng/professeurs_recherche/p_liste/p_fiche.php?num=89

Table of Contents for the Digital Edition of research@hec - Issue#4

Cover & Contents
What is the role of a research professor?
The Dog That Did Not Bark, by Jacques Olivier
HR and Gender Parity, by Jacqueline Laufer
Transparency and Responsibility, by Martin Messner

research@hec - Issue#4