Can Short-sellers Predict Returns? Daily Evidence

We test whether short-sellers in U.S. stocks are able to predict future returns based on new SEC-mandated data for 2005. There is a tremendous amount of short-selling activity during the sample: Short-sales represent 24 percent of NYSE and 32 percent of Nasdaq share volume. Our analysis shows that short-sellers primarily target short-term overreaction in stock prices, but they are also able to detect stocks with short-term underreaction. Increasing shortsales predict future negative abnormal returns. A trading strategy based on daily short-selling activity generates significant positive returns. ∗All three authors are at the Fisher College of Business, The Ohio State University. We are grateful for comments from Leslie Boni, Rudi Fahlenbrach, Frank Hatheway, David Musto, René Stulz, and seminar participants at the Ohio State University, the NBERMarket Microstructure Group, and the University of Georgia. We thank Nasdaq Economic Research for data. All errors are our own. There is currently tremendous interest in short-selling not only from academics, but also from issuers, media representatives, state and federal regulators, and from Congress and the Senate. Academics generally share the view that short-sellers help markets correct short-term deviations of stock prices from their fundamental value. This is consistent with examples of famous shortsellers such as Jim Chanos of Kynikos Associates who was an early short-seller in Enron and David Tice of the Prudent Bear Fund who was an early short-seller in Tyco International. Many issuers do not agree. For example, Canadian drug company Biovail and Utah-based online retailer Overstock.com accuse short-sellers of driving their stock price into the ground and have taken their cases to court. Media representatives often characterize short-sellers as immoral, unethical and downright un-American.1 At the federal level, new regulation governing short-sales in U.S. markets came into effect on January 2, 2005. Feeling that the new federal regulation is inadequate, Utah regulators recently passed a bill that clamps down on short-selling in Utah-based companies.2 Washington is also interested in short-selling, and the Congressional Committee of Financial Services (May 22, 2003) and the Senate Judiciary Committee (June 28, 2006) have recently heard testimonies about short-sellers and hedge funds. In this paper, we try to shed some light on the trading strategies used by short-sellers of U.S. stocks. We first test whether short-sellers target stocks with recent price increases (contrarian traders) or recent price declines (momentum traders). We find that short-sellers primarily follow a contrarian strategy. On average, they increase their short-selling activity following positive returns. They also decrease their short-selling activity after negative returns on average. This does not mean that all short-sellers are contrarians. We do find that a smaller group of short-sellers follow a momentum strategy, i.e., they increase short-selling activity following negative returns. To discern whether there is scope for short-sellers to make money on their trades, we also test whether shortselling intensifies on days preceding negative returns. The results show that short-sellers time their trades extremely well relative to short-term price trends, and this is true whether or not they follow a contrarian trading strategy. Stock prices decline significantly the day following increased shortselling activity. In fact, increased short-selling is followed by negative abnormal returns up to five 1For example, John Rothchild in the Bear Book said, “Known short sellers suffer the same reputation as the detested bat. They are reviled as odious pests, smudges on Wall Street, pecuniary vampires.” 2In May, Utah adopted a law that fines brokers that facilitate naked short-selling. The amount can range from $10,000 a day to millions of dollars to cover all unsettled trades. The Utah law is set to take effect on October 1, 2006, but it is is currently being challenged by the Securities Industry Association (SIA).