Bear or Bull Market Indicators?

Joseph Kennedy, the father of President John F. Kennedy and Massachusetts Senator Edward Kennedy, made his fortune by short selling. He sold securities that he had borrowed with the expectation that he would be able to buy them back for a lower price when he had to return them to the lender. The price difference became Kennedy’s profit on the transactions.

Short selling existed for at least three centuries before Kennedy took advantage of it. And despite an occasionally unsavory reputation, the practice has continued since then. Although personal fortunes have been amassed and broken over the years through this strategy, little research has been performed on the impact of short selling on corporations whose securities are shorted. Different analysts have speculated that significant shorting of a security provides a bearish, bullish, or neutral signal for the company that issues the security.

Cause for Concern: Short selling of your firm’s securities

A research project headed by Bala Balachandran, professor of accounting information and management at the Kellogg School, has provided empirical evidence about the impact of short selling. “Our examination reveals that large short positions are bearish signals,” the group reports in The Journal of Finance, Their results suggest that executives of corporations whose securities experience significant short selling should worry about their firms’ futures.

The results confirm the view among some traders that heavy shorting indicates problems.Previous studies had failed to establish a definitive relationship between shorting and the fate of the shorted stock. The absence of predictable trends inspired Balachandran and his collaborators—Hemand Desai of Southern Methodist University, K. Ramesh of Analysis Group/Economics, and S. Ramu Thiagarajan of Mellon Capital Management—to try to identify a definitive connection.

The team chose the National Association of Securities Dealers Automated Quotient (Nasdaq) market as the source for their data. “Nasdaq depends on more technology-oriented industries with shorter lifetimes for their products,” Balachandran explains. “People can take advantage to make money by selling the companies short. We have demonstrated that they have made significant money doing so.” The team had another reason for focusing on Nasdaq. “It’s different,” Balachandran adds, “and there was a huge interest in it.”

The researchers reviewed Nasdaq returns from June 1988 to December 1994. They determined the extent of stock shorting by using data that the Nasdaq exchange provided on the fifteenth of each month during that period. The team focused on firms that it regarded as being heavily shorted—those with at least a 2.5 percent ratio of shares sold short relative to the total number of outstanding shares. To determine the effects of such heavy shorting on a stock’s behavior, the team relied on a so-called calendar-time portfolio approach. This approach groups together all firms in the sample each month. “The data was a new creation,” Balachandran notes. “So was the research methodology—a two-stage regression and more sophisticated statistical techniques.”

The team used the data to identify firms with “negative abnormal returns”—heavy, but not necessarily disastrous, losses. “You can lose your shirt, but not your whole skin,” Balachandran points out.

Bear, Bull, or Something Else Altogether?

Ultimately the team sought to assess the accuracy of three different hypotheses on the relationship between shorting a stock and the stock’s likely returns. One takes a bearish view, suggesting that because shorting a stock involves a lot of risk, traders who do so have legitimate reason to believe that the stock is destined to fall in value. The second view, popular on Wall Street, asserts that strong interest in shorting a stock is a bullish signal, because it represents latent demand for the stock that will eventually push up its price. Finally, some analysts believe that short selling is largely motivated by hedging strategies, arbitrage transactions, and tax-related reasons; thus it has no relation to stock returns.

“The results were quite intriguing,” states Balachandran. They were also clear. The researchers report that firms with large short positions experience negative and significant abnormal returns when they are heavily shorted. “The negative abnormal returns are increasing in the level of short interest, suggesting that a higher level of short interest is a stronger bearish signal” they assert in The Journal of Finance. The results are consistent with short sellers having private information, and the team’s results also suggest that short sellers target highly liquid firms whose prices are high relative to their fundamentals.

Balachandran and his colleagues have complete confidence in the results. “Our database allows us to take different cuts, including outliers,” he explains. “The research methodology was, in my opinion, foolproof; it has no data bias. We made sure that our results are robust.”

The results confirm the view among some traders that heavy shorting indicates problems. “Now the gut feel is supported by fundamental research,” says Balachandran. “We have established credibility and have shown why it happened.” And what do the results imply for brokers tempted to sell short? “Follow the guys who have made money that way,” Balachandran advises. “If that can be augmented by hardcore research, it is a model for making money.”