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Short sellers and the informativeness of stock prices with respect to future earnings

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Abstract

We examine whether short interest improves the informativeness of stock prices with respect to future earnings. We find that short selling strengthens the relation between current returns and future earnings, especially in settings where short sellers are likely to possess an information advantage, such as when a firm’s information environment is weak or when analysts are highly optimistic about future earnings growth. Collectively, our results illustrate the important role that short sellers play in improving the extent to which current stock prices reflect information about future earnings and thus in improving market efficiency.

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Notes

  1. Gerard and Nanda (1993) develop a model that predicts that short sellers can manipulate seasoned equity offering offer prices to generate profits. Specifically, because seasoned equity offerings are priced at a discount relative to the secondary market price on the day before the offering, informed traders can manipulate the offering price and make large profits by selling heavily in the secondary market just before an offering and then bidding on the underpriced stock afterward. Henry and Koski (2010) empirically confirm these predictions, revealing that short selling makes stock prices less efficient in the days leading up to seasoned equity offerings.

  2. Abusive naked short selling is a practice in which an investor sells a stock short without first arranging to borrow the stock and cannot deliver the stock on the settlement date. Critics argue that naked short positions are used to drive down stock prices and that these short sellers did not intend to deliver the shares when the short position was taken.

  3. See “Overstock.com CEO Patrick Byrne on Worldstock, education, and Wall Street corruption” (2011). Available at http://www.overstock.com/Patrick-Byrne/7371/static.html.

  4. See “SEC bans short-selling” in CNNMoney.com (September 19, 1998). Available at http://money.cnn.com/2008/09/19/news/economy/sec_short_selling/.

  5. Collins and Kothari (1989, p. 145) define a firm’s information environment as “all sources of information relevant to assessing firm value,” and Collins et al. (1987) suggest that the information environment affects the degree to which information about future earnings is impounded into stock prices.

  6. In addition, Collins et al. (1994) add future returns to the returns-earnings model to control for unanticipated future earnings.

  7. Beber and Pagano (2013) investigate the effects of bans on short selling during the recent financial crisis and find that short selling bans lead to decreased market liquidity and hinder price discovery.

  8. With respect to the costs of short selling, short sellers do not have access to the cash proceeds of their sales until their positions are closed, and equity lending contracts include fees estimated at 1.64 % annually for stocks traded on the New York Stock Exchange and 3.74 % annually for stocks traded on the NASDAQ (Diether and Werner 2011).

  9. Boehmer et al. (2008) report that less than 2 % of all short sales are initiated by individual investors.

  10. We obtain each of the daily time-series of factors used to estimate the Carhart (1997) four-factor model from Kenneth French’s data library, available at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/.

  11. Our inferences from the second-stage models are consistent with those tabulated when IMills t is excluded.

  12. To further mitigate concerns about selection bias, we perform tests to determine the direction of causality in Sect. 3.1.3.

  13. As recommended by Leone et al. (2014), we use robust regression based on MM-estimation to mitigate the impact of influential outliers. Robust regression uses iterated re-weighted least squares to reduce the weights assigned to extreme observations, resulting in consistent and highly efficient estimation even when the sample includes influential observations.

  14. When more analysts follow firms, Ayers and Freeman (2003) find that stock prices reflect future earnings more quickly, and Piotroski and Roulstone (2004) find that more firm-specific, industry, and market-level information is impounded into stock price.

  15. It may be difficult to close short positions in firms with weak information environments because these firms are less heavily traded (Roulstone 2003). This implies that short sellers will take short positions in firms with weak information environments only if they are confident that they have high quality information about future earnings.

  16. The belief that analysts should be better at predicting future performance than are other investors is consistent with the work of Ayers and Freeman (2003), who find that stock prices reflect future earnings more quickly when firms are followed by more analysts.

  17. A short squeeze occurs when the stock price begins to rise and short sellers are forced to close their positions by buying shares, which further increases the stock price and leads to further short seller losses.

  18. Analysts’ long-term growth forecasts are a common proxy for the market’s expectations about future growth (La Porta 1996; Chan et al. 2003; Barniv et al. 2009; Da and Warachka 2011).

  19. We include all control variables from Model (4) when estimating Model (6) except that, when we partition the sample on the median of Numest t , we remove Numest t and the related interactions from the model.

  20. Our sample period ends in 2009 because our models require three years of future earnings and returns.

  21. Specifically, we obtain less than 1 % of our total observations from the online vender shortsqueeze.com. These data cover a period for which we could not obtain short interest data directly from the NASDAQ.

  22. This evidence provides additional support for the inference by Pownall and Simko (2005) that short sellers play a more important role in the capital markets when analyst following is low.

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Acknowledgments

We gratefully acknowledge the many helpful comments and suggestions offered by the editor, Patricia Dechow, and the anonymous reviewers. We also thank Hemang Desai, participants at the 2014 American Accounting Association Annual Meeting, and workshop participants at the University of Arkansas for helpful comments and suggestions. James Myers gratefully acknowledges financial support from the Ralph L. McQueen Chair, and Linda Myers gratefully acknowledges financial support from the Garrison/Wilson Chair, both at the University of Arkansas.

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Authors and Affiliations

  1. Marriott School of Management, Brigham Young University, 521 Tanner Building, Provo, UT, 84602, USA

    Michael S. Drake

  2. Sam M. Walton College of Business, University of Arkansas, Fayetteville, AR, 72701, USA

    James N. Myers & Linda A. Myers

  3. Owen Graduate School of Management, Vanderbilt University, 401 21st Avenue South, Nashville, TN, 37203, USA

    Michael D. Stuart

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  1. Michael S. Drake
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Drake, M.S., Myers, J.N., Myers, L.A. et al. Short sellers and the informativeness of stock prices with respect to future earnings. Rev Account Stud 20, 747–774 (2015). https://doi.org/10.1007/s11142-014-9313-8

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