Can Short-sellers Predict Returns? Daily Evidence

Abstract

We test whether short-sellers in Nasdaq-listed stocks are able to predict future returns based on new SEC-mandated data for the first six months of 2005. There is a tremendous amount of short-term trading strategies involving short-sales during the sample: Short-sales represent 27 percent of Nasdaq share volume while monthly short-interest is about 3.1 percent of shares outstanding (5.5 days to cover). Short-sellers are on average contrarian -they sell short following positive returns. Increasing short-sales predict future negative returns, and the predictive power comes primarily from small trades. A trading strategy based on daily short-selling activity generates significant returns, but incurs costs large enough to wipe out any profits. * 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 NBER Market Microstructure Group, and the University of Georgia. We thank Nasdaq Economic Research for data. All errors are our own.Many market observers accuse short-sellers of destabilizing markets by selling stocks (they do not even own) when prices are already trending downward, exacerbating the negative momentum. Issuers and journalists often characterize short-sellers' activities as immoral, unethical and downright un-American. 1 Academics and traders instead argue that short-sellers stabilize security prices by selling stocks when prices exceed fundamental values, thus helping correct market overreaction. Short-term over-reaction could be caused by impediments to short-selling, as high costs of executing short-sales may result in stock prices reflecting the opinions of optimistic investors only (Miller (1977)). 2 Some researchers have even argued that costly short-selling was one of the culprits behind the stock market bubble of the late 1990s (e.g., Ofek and Richardson (2003)).In this study, we use the SEC mandated tick-by-tick short-sale data for 2,815 Nasdaq-listed stocks for the period January 3, 2005 to June 30, 2005 to test whether short-sellers are contrarian or momentum traders and whether they are able to predict future returns. We test these hypotheses by studying the link between short-selling activity and future returns and how short-sellers react to past returns on a daily level.The literature on short-selling is growing rapidly. Most previous studies have used monthly stock-specific short interest data (e.g., Figlewski and Webb (1993), Figlewski (1981), Dechow, Hutton, Meulbroek, and Sloan (2001), Desai et al (2002), Asquith, Pathak, and Ritter (2005), and Singal and Xu (2005)). There are three important problems with using monthly short interest data.First, the monthly reporting frequency does not permit researchers to study short-term trading strategies. Second, monthly short interest data does not distinguish between the short interest of dealers (who are exempt from short-sale restrictions) from th...

REIT Short Sales and Return Predictability

“…Boehmer and Wu (2007) find that short sellers target stocks that become out of line with their fundamental value and add to the informational efficiency in security prices by shorting stocks that are mispriced. Consistent with this argument, Diether et al (2009a) show that short sellers are contrarian in contemporaneous and past returns suggesting that short sellers target overvalued equities. 1 This paper examines short selling activity of real estate investment trusts (REITs), an industry which has been ignored in the short selling literature.…”

“…Boehmer et al (2008) and Arnold et al (2005) find short activity is a function of the size of firm and security's trading activity, so a security's market capitalization should affect short selling activity. Diether et al (2009a) document that price volatility positively affects the level of short selling. If short sellers are informed, as the literature suggests, then the level of short selling will be a function of information flow.…”

“…If short sellers are informed, as the literature suggests, then the level of short selling will be a function of information flow. 9 Following Diether et al (2009a), we calculate price volatility as the difference in daily high and low price to the daily high price. Finally, Boehmer et al (2008) and Diether et al (2009a, b) show that short selling activity is a function of trading activity, so we also match based on volume.…”

“…Dolvin and Pyles (2009) show REIT initial public offerings are associated with lower levels of underpricing and smaller price revisions than those for non-REITs and attribute these findings to reduced uncertainty in pricing REIT securities. As shown by Boehmer and Wu (2007) and Diether et al (2009a), a major motivation for short sellers is to find overpriced securities. Since fewer REITs are likely to be mispriced, traders are expected to find it more difficult to profit from short selling REIT stocks.…”

“…3 These regulatory provisions affect overall corporate strategy and asset allocation for REITs. For instance, REITs must pay a dividend equal to 90% of taxable income, which 1 D' Avolio (2002) and Diether et al (2009a) argue that costs of short selling are relatively low, however, their samples exclude REITs. 2 Another reason for examining characteristics of REIT short selling activity is mentioned by Danielsen and Harrison (2000) who point out that investors cannot short real estate investments outside of the public market.…”