Finance & Accounting Leadership Jun 1, 2008

Bear or Bull Mar­ket Indicators?

The impact of short selling

Based on the research of

Hemang Desai

K. Ramesh

S. Ramu Thiagarajan

Bala V. Balachandran

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.”

About the Writer

Peter Gwynne

About the Research

Hemang Desai, K. Ramesh, S. Ramu Thiagarajan, and Bala V. Balachandran: An Investigation of the Informational Role of Short Interest in the Nasdaq Market, The Journal of Finance, LVII, no. 5, October 2002, 2263-2287.

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