Equity Overvaluation and Short Selling

The following post comes to us from Messod Daniel Beneish, Professor of Accounting at Indiana University, Bloomington; Charles M. Lee, Professor of Accounting at Stanford University; and Craig Nichols, Assistant Professor of Accounting at Syracuse University.

In our paper, In Short Supply: Equity Overvaluation and Short Selling, which was recently made publicly available on SSRN, we use detailed equity lending data to examine the role of constraints on equity prices. We find that constrained stocks underperform, the short interest ratio (SIR) has a nonlinear association with constraints, constrained stocks have negative returns regardless of short interest ratio, high short interest yet unconstrained stocks do not underperform, yet low short interest unconstrained stocks outperform. Moreover, we show that limited supply is a key feature distinguishing constrained and unconstrained stocks, and that among constrained stocks, those with the lowest supply have the strongest negative returns. Our findings confirm that supply varies across firms (in contrast to SIR, which assumes supply is 100 percent of outstanding shares for all stocks) and short supply in the equity lending market has implications for the informational efficiency of equity prices.

Because our data spans a wide cross section of stocks over an 88-month period, we examine the role of constraints and lending supply on various trading strategies proposed in the literature. We find that the short side returns to these strategies exist in the constrained, hard to borrow, special stocks only; we do not observe significant negative returns among stocks that remain easy to borrow. Moreover, special stocks have much lower supply yet have similar levels of demand relative to general collateral stocks. Thus, equity lending constraints appear to make the short side returns in prior literature unavailable, and short supply seems to be the primary constraint.

Our conclusions are subject to several limitations. Our tests of the role of constraints on equity pricing involve the joint hypothesis that our measure of constraints is valid. Although the strong results from our tests suggest this joint hypothesis holds, to the extent we measure constraints with error, our ability to detect the pricing implications of constraints is weakened. Moreover, our study focuses on the consequences of limited supply. Thus, we take supply as given, but acknowledge that a better understanding of supply is warranted. Indeed, our results indicate that supply of lendable shares matters, and thus motivate additional research into the determinants of supply in the securities lending market.

Our findings should interest regulators, researchers, and traders, among others. For regulators, our findings suggest that improving supply can lead to improved market efficiency. For researchers, our findings help better understand the existence and longevity of short side returns to various trading strategies. We also demonstrate the forces that shape the short interest ratio, which remains a central variable of interest in capital markets research in the area of short selling. For traders, our results suggest caution in attempting to use the short interest ratio and other firm characteristics in forming a short position; the stocks that remain easily available to short for the typical marginal investor are likely not mispriced.

The full paper is available for download here.

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