Research Findings

Identify overvalued stocks, act as ‘safety valves’

Short sellers can systematically identify relatively overvalued stocks. Highly shorted stocks earn significantly lower risk-adjusted returns over the next 60 days when compared to lightly shorted stocks.

Ekkehart Boehmer, Charles M. Jones, and Xiaoyan Zhang. “Which Shorts are Informed?” Journal of Finance, 2008, 63: 491-527

“Our evidence suggests that short sellers act as specialized monitors who generate value-relevant information in the stock market” about “future fundamental value, especially for stocks with low institutional ownership.”
Ferhat Akbas, Ekkehart Boehmer, Bilal Erturk, and Sorin M. Sorescu. “Why Do Short Interest Levels Predict Stock Returns?” (March 10, 2008).

“Short sellers effectively act as a safety valve for companies in distress. Instead of curbing their activities (which only exacerbates the problem), short sellers should be encouraged in order to bring share prices back to realistic levels. In other words, short sellers can ‘correct’ market prices. In this scenario, short sellers effectively neutralise ‘irrational exuberance’ in the economy.”

P.A.C. Saffi and Kari Sigurdsson. “Are Short Sellers Stakeholders?” Working Paper 2007. London Business School.

Increase information flowing to investors — greater efficiency in securities pricing

Daily shorting flows are positively related to several measures of informational efficiency. Short sellers are highly informed traders; their information moves prices for several weeks. When Professor Julie Wu examined the relationship between shorting and market efficiency in light of Regulation SHO (reduced restraints on short sales for a limited number of stocks), she found that the pilot stocks experienced “some improvements in price efficiency that are associated with increased shorting activity following the removal of the tick test. . . .These results provide additional support to the key finding that short sellers directly contribute to greater price efficiency.”

Julie Wu, “Short Selling and the Informational Efficiency of Prices.” 2007 Working Paper. Texas A&M University.

Ekkehart Boehmer and Eric Kelley,”Institutional Investors and the Informational Efficiency of Prices.” 2007 Working Paper.Texas A&M University.

Focus investors’ attention on companies’ fundamentals

Short sellers are able to predict downward analyst forecast revisions and anticipate earnings restatements. Further, “Our evidence suggests that the information short sellers exploit mainly concerns the market’s misperception of these firms’ fundamentals (as measured by future profitability),” according to researchers at Duke University.

Jennifer Francis, Mohan Venkatachalam, and Yun Zhang, “Do Short Sellers Convey Information about Changes in Fundamentals or Risk?” 2005 Working Paper. Duke University.

H. Desai, S. Krishnamurthy, and K. Venkataraman. “Do Short Sellers Target Firms with Poor Earnings Quality?: Evidence from Earnings Restatements.” Review of Accounting Studies (2006) 11: 71-90.

Negative earnings surprises are preceded by abnormal short selling.

Stephen E. Christophe, Michael G. Ferri, and James J. Angel. “Short-selling Prior to Earnings Announcements.” Journal of Finance (2004) 59: 1845-1875.

Improve market quality

“We find no support for the short-selling opposition’s argument that short-selling disrupts orderly markets by causing panic selling, high volatility, and market crashes. Collectively, our empirical evidence shows that allowing short sales improves market quality.”

Hazem Daouk and Anchada Charoenrook, “A Study of Market-Wide Short-Selling Restrictions.” February 2005.

Counter overpricing if constraints aren’t imposed

Constraints on short selling, whether formal and legalistic, or informal and cultural, can lead to overpricing of securities. Overpriced securities are likely to have low future returns until the overpricing is fully corrected. “We find strong evidence to support [other] hypotheses . . . that short-sale constraints are associated with less price efficiency.” They also show that fewer short-selling constraints are not associated with a higher proportion of sharp falls in stock prices.

Pedro A. C. Saffi and Kari Sigurdsson, “Price Efficiency and Short-Selling.” December 10, 2007. AFA 2008 New Orleans Meetings Paper.

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