Blog - Investing Notes
January 11, 2005 –
Buffering Exuberance
In their December 2003 paper on
"Aggregate Short Interest and Market Valuations" Owen
Lamont and Jeremy Stein examine the countercyclical nature of aggregate short
interest and the aggregate put/call option ratio. They note that, for
individual stocks, demand for shorting correlates with abnormally low future
returns. However, for stocks in aggregate, they conclude that:
- During 1995-2002, the return on the NASDAQ index
over the prior 12 months has a correlation of -.54 with the
aggregate short interest ratio and -.63 with the aggregate put/call
ratio. During 1960-2002, the correlation between the annual
short-sales ratio and NYSE return is -.51.
- Because of weak (strong) performance in a rising
(falling) market, short sellers lose (gain) capital and scale back
(up) aggregate short interest. They are therefore less effective
in buffering broad market sentiment shifts than in enforcing the
rational pricing of individual stocks.
- Initial Public Offerings and secondary offerings
perform a quasi-shorting role for the overall market during market
bubbles.
In summary, short selling is more effective at buffering
exuberance for individual stocks than for the overall market.
For related research, see
Blog Synthesis: Short Selling and Short Interest.
