Blog - Investing Notes

February 14, 2005 – Extra! Short Selling Shocks Stocks

In their February 2005 paper entitled "The Link Between Short Sale Constraints and Stock Prices", Lauren Cohen, Karl Diether and Christopher Malloy isolate supply and demand shifts in equity lending to examine shorting demand as an indicator, and cause, of future stock returns. Using actual share loan prices and quantities from a large institutional investor during August 1999 to July 2003, they find that:

• Increases in shorting demand for individual stocks leads to negative abnormal returns averaging 2-3% per month. This effect is largest when other information about the stocks is scarce.
• Increases in shorting supply (for example, as institutions acquire additional shares that can be lent) also depress returns, but with greater variability.
• Since the effect is not always associated with other information flow about shorted stocks, shorting demand (investor sentiment) itself may cause negative returns.

In summary, short selling shocks move stock prices ipso facto. They are news in and of themselves. In the absence of contrary information or reactive strategies, investors should avoid short-shocked stocks.

We think that short-sellers rely not only on their convictions regarding individual stocks but also information about peer stocks (sectors) and investor behavior (how investors respond to drops in share price).

For related research, see Blog Synthesis: Short Selling and Short Interest.