Which Shorts are Informed?

Abstract

We use a long, recent panel of proprietary system order data from the New York Stock Exchange to examine the incidence and information content of various kinds of short sale orders. On average, at least 12.9% of NYSE volume involves a short seller. As a group, these short sellers are extremely well-informed. Stocks with relatively heavy shorting underperform lightly shorted stocks by a risk-adjusted average of 1.07% in the following 20 days of trading (over 14% on an annualized basis). Large short sale orders are the most informative. In contrast, when more of the short sales are small (less than 500 shares), stocks tend to rise in the following month, indicating that these orders are uninformed. We partition short sales by account type: individual, institutional, member-firm proprietary, and other, and we can distinguish between program and non-program short sales. Institutional non-program short sales are the most informative. Compared to stocks that are lightly shorted by institutions, a portfolio of stocks most heavily shorted by institutions on a given day underperforms by a risk-adjusted average of 1.36% in the next month (over 18% annualized). These alphas do not account for the cost of shorting, and they cannot be achieved by outsiders, because the internal NYSE data that we use are not generally available to market participants. But these findings indicate that institutional short sellers have identified and acted on important value-relevant information that has not yet been impounded into price. The results are strongly consistent with the emerging consensus in financial economics that short sellers possess important information, and their trades are important contributors to more efficient stock prices. WHICH SHORTS ARE INFORMED?A number of theoretical models, beginning with Miller (1977) and Harrison and Kreps (1978), show that when short selling is difficult or expensive, stocks can become overvalued as long as investors agree to disagree on valuations. There is a horde of much more recent empirical evidence which uniformly supports this proposition. There is now a consensus, at least in the financial economics literature if not on Main Street, that short sellers occupy a fairly exalted position in the pantheon of investors for their role in keeping prices in line.But there is surprisingly little direct evidence that short sellers know what they are doing, that they are any different from or better informed about fundamentals than other investors.There is plenty of indirect evidence. For example, Aitken et al. (1998) show that in Australia, where short sales are immediately disclosed to the public, the reporting of a short sale causes prices to decline immediately. Jones and Lamont (2002) show that when the price of shorting rises (indicating either an increase in shorting demand or a decline in the supply of lendable shares), stock prices soon fall. Cohen, Diether, and Malloy (2005) cleverly separate these two and show that it is the increase in shorting demand that is associated with...

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