The predictive power of short-selling stocks over stock prices comes from two channels: (1) the ability of short sellers to anticipate price movements and (2) the restrictions on short selling. The effects of the channels on stock prices are based on the information hypothesis and the overpricing hypothesis. Short sellers are shown to be informed traders, but because of short-selling restrictions, prices do not reflect all information that is present in the market.
The information hypothesis (IH) states that the prevalence of short sellers who are well-informed investors should lead to an increase in demand for short selling and result in lower returns, whereas the overpricing hypothesis (OH) states that if short-sale constraints on investors are relaxed, stock prices will fall. To test both hypotheses, the authors observe separately the evolution of the demand for short selling and the supply of stock lending over time.
How Is This Research Useful to Practitioners?
The authors find that an increase of one standard deviation in the total number of shares loaned in a given week generates a 12 bp decrease in the stock price in the two weeks following the increase. In addition, an increase of one standard deviation in the total number of shares offered for lending through the electronic market in a given week leads to a 27 bp decrease in the stock price in the two weeks following the increase. They also notice that although the decline in share prices reaches its maximum effect two weeks following the increase in stock lending, short-selling restrictions seem to have longer-term effects on stock prices by up to four weeks.
The authors conclude that short sellers are informed traders (leading to the IH), but because of the short-selling restrictions, they are unable to sell short as much as they are willing to and prices do not reflect all market information (leading to the OH).
How Did the Authors Conduct This Research?
Because of the decentralized nature of stock-lending markets in most countries where stock loan transactions are conducted over the counter, neither short-selling demand nor stock-lending supply can be observed in these markets. This issue makes it difficult to test the OH and IH separately.
The authors rely on a dataset of stock-lending activity in Brazil, where the stock-lending market is centralized. On the basis of the dataset, they propose empirical strategies to help identify the effects of shifts in short-selling demand and stock-lending supply on stock prices. Short-run future returns of shares that are loaned in a week are regressed against variables that represent the lending supply curve—the number of shares offered for lending through electronic markets and the average lending fees.
Two separate effects are studied to test the IH and OH: Effect A is the effect on stock prices of shifts to the right in the short-selling demand curve, and Effect B is the effect on stock prices of shifts to the right in the lending supply curve alongside shifts to the left in the short-selling demand curve. The IH is proven if Effect A is negative, whereas the OH is proven if both Effects A and B are negative.
Accounting for the varying degree of controls on short selling in different markets, a savvy investor could form reasonable opinions of short-run movements in stock prices by observing buildups in short positions that are reportable and thus lead to financial opportunities.