Large percent increases in short interest predict negative future returns over short horizons, of a month or several days, although the relation is weak. It is clear, however, that short sellers tend to target stocks that have recently increased in price, or that have historically optimistic fun- damentals, such as low book-to-market ratios. This indicates that short sellers attempt to profit from mean reversion, and since it is well known that mean reversion in stock prices is a long-horizon process, it should not be surprising that we observe that short sellers earn larger profits
34See, Stephen E. Christophe, Michael G. Ferri, and James J. Angel, “Short-Selling Prior to Earnings Announcements,” Working paper, George Mason University (No- vember 2002); and James J. Angel, Stephen E. Christophe, and Michael G. Ferri, “A Close Look at Short Selling on NASDAQ,” Financial Analysts Journal (November/
December 2003), pp. 66–74.
over long horizons, of up to two years. This, however, implies that short interest must accumulate, over time, before it contains any material information about future returns. Considering this accumulative process in their tests was thus the key insight of Asquith and Muelbroek who detect a very strong negative relation between accumulating RSI and long-term future returns.
More recent (post-1994) evidence, however, suggests that the emer- gence of hedge funds has weakened this signal, either as a result of their speculation on short interest or their hedging activities, both of which would obscure the information content of short interest. The post-1994 returns, to trading on short interest, appear large enough to survive the direct monetary costs of short selling. Whether they represent excessive compensation, however, is not so clear given the potential difficulties in borrowing shares and the risks of an early recall or a short squeeze.
Thus, on the one hand, these results may be interpreted as consistent with Fama who defines an efficient capital market as one in which trad- ers reflect information in prices only to within the cost of attaining and trading on the information. On the other hand, if noise traders impact the risks of a recall or a short squeeze, and they certainly may, then mar- ket efficiency exists only in the sense of the limits to arbitrage argument of Andrea Shleifer and Robert Vishny.
Most of the evidence presented here is consistent with the academic theories of either Miller or Diamond and Verrecchia. Short-sale con- straints clearly result in overpricing, and there definitely is information content in short interest data, although it may be difficult to exploit.
Short sellers’ profits come from taking advantage of the reversion of prices back, down, to the mean. There is no evidence to support the tra- ditional technical analysts’ bullish view of high short interest, which actually relies on a reversion in prices back, up, to the mean. This bull- ish view of short interest appears to be rooted more in a fear of recalls and short squeezes than anything else. Some practical implications are listed below.
■ Large percent increases in short interest are a weak signal of negative short-term returns. Other measures of short interest are weaker yet.
■ Accumulating and sustaining levels of RSI are strong signals of nega- tive returns in the long-term, although this relation is somewhat weaker post-1994. In addition, optimal entry and exit may be tricky with the accumulating short interest strategy. “Short spikes,” especially those that have been sustained, represent an attractive point of entry.
■ Traded put options in a stock may obscure the information content of the stock’s short interest figure.
■ Arbitrage and hedging activities in a stock may obscure the informa- tion content of the stock’s short interest figure.
■ The short interest data reported in the print media are incomplete and includes only stocks with very large levels or changes in aggregate short interest.
■ Rebate rates are usually not available to individual investors.
■ For stocks in high demand to borrow, rebate rates may be negative:
meaning that the short seller must pay interest to the equity lender because the loan fee exceeds the cost of funds.
■ It may be difficult to borrow stocks in high demand, especially if their loan fee is “sticky” low, and the risk of recall is higher in this situation.
■ Identifying stocks before they are in high demand to borrow insures the ability to borrow at a modest loan fee. This may be done by studying the determinants of short interest. Recall that stocks with high valua- tions attract short sellers. Unfortunately, an early recall is more likely if the stock later becomes popular to borrow but your loan fee is low.
■ Watch out for short squeezes! Avoiding them, as well as recalls, appears to be the logic behind the traditional technical analysts’ view of high short interest. An example of a possible short squeeze set off by high short interest is that of Martha Stewart Living Omnimedia stock in January 2004. Investors scorned the stock through much of 2003 because in June 2002, Stewart had been tied to an insider-trading scan- dal at ImClone Systems. She was also charged with illegally trying to prop up the stock of her own company and deceive its shareholders.
Although Stewart stepped down as CEO and chairwoman of the com- pany after being indicted, Martha Stewart Living continued to struggle with slumping sales and earnings. But from mid-December 2003 to the end of January 2004, shares of Martha Stewart Living climbed from just over $9 to $13.39—its highest level in 19 months. Those bullish on the stock stated that the rally was a result of investors believing that closure would soon come with the end of the case and that, regardless of the outcome, the company would thrive once its executives got back to focusing on the business, rather than the trial. Technician’s, however, claimed the rise was due in part to a short squeeze resulting from high short interest and the associated increase in demand to cover. More than 50% of the shares available for trading had been shorted during the December 2003 through January 2004 period.
■ The only reason to buy or hold a stock with high short interest is if you have reason to believe that a short squeeze may soon come into play.
■ Higher frequency reporting of short interest or greater transparency of short-sale transactions may actually reduce the informational efficiency of a market.
SECTION
Three
Short Selling Strategies
CHAPTER 10
259
Spotting Clues in Qs
Ron Gutfleish, Ph.D.
Elm Ridge Capital Lee Atzil Elm Ridge Capital
horting stocks is both difficult and frightening. The upside is limited while the downside is not. One competes against the market’s long- term positive slope, other investors, and the companies’ management teams, all trying to make shorts lose money. A short strategy needs to take into account these factors as well as the psychological limits of those implementing it. One needs to decide: (1) What kinds of targets to pursue; (2) how to screen for potential candidates; (3) how to vet them;
and—most importantly—(4) how to live with them. In this chapter, we’ll discuss how we deal with these issues, as well as providing a few exam- ples (with the company names withheld in order to protect the innocent/
guilty) along the way. We want to note at the outset that there are many approaches to shorting stocks. The following is our crack at it. But before reviewing our strategy, we would like to insert a quick caveat.
We are not dedicated short-sellers, but instead run a somewhat bal- anced long-short portfolio. Hence, we are sometimes willing to accept losses on the short side, if they can be balanced by gains on the long one. In practice, that means that we can take aim at short targets that could be bailed out by some macro development, provided that we have longs we think would benefit as well. A dedicated short seller does not have this luxury.
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