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short_sellers_predict_returns - Can Short-sellers Predict...

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Can Short-sellers Predict Returns? Daily Evidence Karl B. Diether, Kuan-Hui Lee, Ingrid M. Werner * This Version: November 17, 2005 First Version: June 17, 2005 Comments are Welcome 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 follow- ing 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 ac- tivity 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.
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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 momen- tum. 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 over- reaction. 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.
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