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Buffering Exuberance

Posted in Short Selling

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.

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