Short selling and the independence of business-related analysts: Evidence from an emerging market

This paper investigates whether short-sale deregulation improves analysts' independence in an emerging market where conventional mechanisms mitigating conflicts of interest are either ineffective or absent. Short selling reduces the effectiveness of analysts' favourable opinions in creating or sustaining overvalued stock prices, thus decreasing the incentives of institutional clients of brokerages to exert pressure on related analysts to initiate coverage and issue biased opinions. Using a difference-in-difference approach, we find strong evidence that stocks that are eligible for short sales experience a greater reduction in coverage by related analysts than stocks that are ineligible for short sales. When covered firms become eligible for short sales, the quality of forecasts and recommendations issued by related analysts improves considerably. Further analyses show that shortable firms with a significant reduction in related analysts' coverage are more likely to underperform and to experience stock price crashes in the future. Altogether, our results are consistent with short selling effectively restoring related analysts' independence in emerging markets.     

Pricing deviation,misvaluation comovement,and macroeconomic conditions

We measure an individual stock’s misvaluation based on the deviation of its price from predicted intrinsic value. Both under- and overvalued stocks identified by this misvaluation measure exhibit greater valuation uncertainty and arbitrage difficulty, and the misvaluation measure strongly predicts stock returns incremental to size, book-to-market ratio, past returns, and various return anomalies. Based on the misvaluation measure, we form a misvaluation factor and find that stock return covariances with this factor possess significant and robust return predictive power. We further show that the misvaluation factor predicts future economic conditions, providing additional insight into the real effect of systematic misvaluation in the stock market.     

Do arbitrageurs amplify economic shocks?

We test the hypothesis that arbitrageurs amplify economic shocks in equity markets. The ability of speculators to hold short positions depends on asset values. Shorts are often reduced following good news about a stock. Therefore, the prices of highly shorted stocks are excessively sensitive to shocks compared with stocks with little short interest. We confirm this hypothesis using several empirical strategies including two quasi-experiments. In particular, we establish that the price of highly shorted stocks overshoots after good earnings news due to short covering compared with other stocks.     

Are Short Sellers Informed? Evidence from the 2007–2008 Subprime Mortgage Crisis

This paper examines the short selling activities around financial firms’ announcements of asset write‐downs during the 2007–2008 subprime mortgage crisis. We find that short sellers accumulate short positions prior to write‐down announcements, and that stocks experience significantly negative returns around such announcements. These results suggest that the return predictability of short interests is due to short sellers’ informational advantage. Furthermore, we show that short sellers increase their positions significantly in the announcement month and keep increasing their positions afterward, suggesting the feedback effect of the disclosed write‐downs on financial firms’ existing exposures. The valuable information contained in the short interest should encourage regulators to mandate stock exchanges disclose short selling activities more frequently.     

Are extreme returns priced in the stock market? European evidence

This paper revisits some recently found evidence in the literature on the cross-section of stock returns for a carefully constructed dataset of euro area stocks. First, we confirm recent results for US data and find evidence of a negative cross-sectional relation between extreme positive returns and average returns after controlling for characteristics such as momentum, book-to-market, size, liquidity and short term return reversal. We argue that this is the case because these stocks have lottery-like characteristics, which is attractive to certain investors. Also, these stocks tend to be very volatile so that arbitrageurs are discouraged from correcting potential mispricing. As a consequence, these stocks are often overpriced and hence face lower expected returns. Second, when we control for extreme returns, the recently found negative relationship between idiosyncratic risk and future returns is less robust. In our models, after adding maximum returns, the relationship is insignificant and sometimes even positive. We also find that idiosyncratic skewness and coskewness play an important role for asset pricing, as predicted by several theoretical models.     

Is Gold a Hedge or a Safe Haven? An Analysis of Stocks,Bonds and Gold

Is gold a hedge, defined as a security that is uncorrelated with stocks or bonds on average, or is it a safe haven, defined as a security that is uncorrelated with stocks and bonds in a market crash? We study constant and time‐varying relations between U.S., U.K. and German stock and bond returns and gold returns to investigate gold as a hedge and a safe haven. We find that gold is a hedge against stocks on average and a safe haven in extreme stock market conditions. A portfolio analysis further shows that the safe haven property is short‐lived.     

The good news in short interest

Stocks with relatively high short interest subsequently experience negative abnormal returns, but the effect can be transient and of debatable economic significance. In contrast, relatively heavily traded stocks with low short interest experience both statistically and economically significant positive abnormal returns. These positive returns are often larger (in absolute value) than the negative returns observed for heavily shorted stocks. Thus, the positive information associated with low short interest, which is publicly available, is only slowly incorporated into prices, which raises a broader market efficiency issue. Our results also cast doubt on existing theories of the impact of short sale constraints.     

Short Sales Constraints and Momentum in Stock Returns

Abstract:   We show that stock characteristics identified by D'Avolio (2002) provide a reliable index of the mostly unobservable short sales constraints. Specifically, we find that this index is positively related to the level of short interest and to short selling costs implied by the disparity in prices in the options and stock markets, and is negatively related to future returns. Using this index, we show that the magnitude of momentum returns for the period 1984 to 2001 is positively related to short sales constraints, and loser stocks rather than winner stocks drive this result. We conclude that short sales constraints are important in preventing arbitrage of momentum in stock returns.     

Daily short interest,idiosyncratic risk,and stock returns

This paper examines the relation between short selling and returns and the impact of arbitrage costs on short sellers’ behavior. Using daily UK short selling data, we find that stocks with low short interest levels experience significant positive returns on both an equal- and value-weighted basis. Economic theory predicts that short sellers avoid establishing positions in stocks with high idiosyncratic risk. Our results indicate a negative relation between short interest and returns among high idiosyncratic risk stocks and that short selling activity is mostly concentrated in low idiosyncratic risk stocks where it is less costly to arbitrage fundamental risk.     

The 2008 short sale ban: Liquidity, dispersion of opinion, and the cross-section of returns of US financial stocks

This study examines the cross-sectional impact of the 2008 short sale ban on the returns of US financial stocks. Motivated by the large cross-sectional variation in the extent to which banned stocks suffer an illiquidity shock, we hypothesize that stocks with larger liquidity declines are associated with poorer contemporaneous stock returns. The evidence supports this hypothesis and suggests that this effect is stronger for more liquid stocks, as predicted by Amihud and Mendelson (1986). Moreover, consistent with Miller’s (1977) model, we report a valuation reversal whereby stocks with higher abnormal returns at the onset of the ban have lower abnormal returns at its removal. Our findings are robust when we control for firms most affected by TARP, include non-banned matched firms, and compare banned firms’ stock returns with their bond returns. From a policy standpoint, the ban reduced valuations, ceteris paribus, of the stocks that were hardest hit by illiquidity.     

Correlation and return dispersion dynamics in Chinese markets

This paper studies the relation between firm-level return dispersions and correlations among Chinese stocks during periods of unusually large upward and downward swings. We analyze individual stock returns across 18 sectors and test if return dispersions and stock correlations show asymmetric patterns for extreme up and down markets. Evidence from studies on U.S. stocks suggests that equity return correlations tend to be much greater on the downside than on the upside and that the degree of comovement gets even stronger during extreme market states. However, in the case of Chinese stock market, we find that higher downside correlations apply to only stocks within the Financial sector. With the exception of Financial stocks, we find that stock correlations are significantly higher during up markets, rather than down markets. Regarding firm-level return dispersions, our findings are consistent with rational asset pricing model predictions. We find that equity return dispersions are significantly higher during periods of large price changes.     

ON THE INFORMATIONAL EFFECT OF SHORT‐SALES CONSTRAINTS: EVIDENCE FROM THE TOKYO STOCK EXCHANGE

Using a database of stock lending fees for Japanese centralized margin transactions, I show that short‐sales constraints reduce the adjustment speed of stock prices to negative information before the announcements of revised earnings forecasts disclosed by firms in the Tokyo Stock Exchange from July 1998 to December 2001. I find that the cumulative abnormal returns (CARs) of the stocks with high short‐sales costs are insensitive to negative information on pre‐announcement days, but the CARs of these stocks become significantly lower than the CARs of the stocks with low short‐sales costs when the announcements reveal negative information to the public.     

Risk,Mispricing, and Value Investing

We evaluate the stock return performance of a modified version of the book-to-market strategy and its implications for market efficiency. If the previously documented superior stock return of the book-to-market strategy represents mispricing, its performance should be improved by excluding fairly valued firms with extreme book-to-market ratios. To attain this, we classify stocks as value or glamour on book-to-market ratios and accounting accruals jointly. This joint classification is likely to exclude stocks with extreme book-to-market ratios due to mismeasured accounting book values reflecting limitations underlying the accounting system. Using both 12-month buy-and-hold returns and earnings announcement returns, our results show that this joint classification generates substantially higher portfolio returns in the post-portfolio-formation year than the book-to-market classification alone with no evidence of increased risk. In addition, this superior stock return performance is more pronounced among firms held primarily by small (unsophisticated) investors and followed less closely by market participants (stock price <$10). Finally, and most importantly, financial analysts are overly optimistic (pessimistic) about earnings of glamour (value) stock, and for a subset of firms identified as overvalued by our strategy, the earnings announcement raw return, as well as abnormal return, is negative. These last results are particularly important because it is hard to envision a model consistent with rational investors holding risky stocks with predictable negative raw returns for a long period of time rather than holding fT-bills and with financial analysts systematically overestimating the earnings of these stocks while underestimating earnings of stocks that outperform the stock market.     

DO INSIDERS PRACTICE WHAT THEY PREACH? INFORMED OPTION EXERCISES AROUND MERGERS AND ACQUISITIONS

We examine executive stock option exercises around a sample of merger and acquisition announcements between 1996 and 2006, focusing on a subset we identify as potentially informed. For stock‐financed acquisitions, we find a surge in informed exercises by acquirer insiders in the year leading up to the acquisition announcement, but target insiders display no similar increase. We find the market reaction upon the announcement for acquirers is negatively related to extreme early exercises and find some evidence of long‐run underperformance. Overall, our evidence indicates that insiders knowingly bid for firms when they personally believe their own firm is overvalued.     

Sell on the news: Differences of opinion,short-sales constraints,and returns around earnings announcements

Miller [1977. Risk, uncertainty, and divergence of opinion. Journal of Finance 32, 1151–1168] hypothesizes that prices of stocks subject to high differences of opinion and short-sales constraints are biased upward. We expect earnings announcements to reduce differences of opinion among investors, and consequently, these announcements should reduce overvaluation. Using five distinct proxies for differences of opinion, we find that high differences of opinion stocks earn significantly lower returns around earnings announcements than low differences of opinion stocks. In addition, the returns on high differences of opinion stocks are more negative within the subsample of stocks that are most difficult for investors to sell short. These results are robust when we control for the size effect and the market-to-book effect and when we examine alternative explanations such as financial leverage, earnings announcement premium, post-earnings announcement drift, return momentum, and potential biases in analysts’ forecasts. Also consistent with Miller's theory, we find that stocks subject to high differences of opinion and more binding short-sales constraints have a price run-up just prior to earnings announcements that is followed by an even larger decline after the announcements.     

Idiosyncratic risk,costly arbitrage,and the cross-section of stock returns

We test a new cross-sectional relation between expected stock return and idiosyncratic risk implied by the theory of costly arbitrage. If arbitrageurs find it more difficult to correct the mispricing of stocks with high idiosyncratic risk, there should be a positive (negative) relation between expected return and idiosyncratic risk for undervalued (overvalued) stocks. We combine several well-known anomalies to measure stock mispricing and proxy stock idiosyncratic risk using an exponential GARCH model for stock returns. We confirm that average stock returns monotonically increase (decrease) with idiosyncratic risk for undervalued (overvalued) stocks. Overall, our results support the importance of idiosyncratic risk as an arbitrage cost.     

Distress risk anomaly and misvaluation

This paper examines the effects of misvaluation on the well-documented negative relation between distress risk and stock returns (distress risk anomaly). Findings indicate that distress risk is negatively related to subsequent stock returns only in the subset of the most overvalued stocks, which is consistent with mispricing explanations provided by prior studies. The distress anomaly disappears after controlling for mispricing effects. Further analysis reveals earnings management to be one possible cause for the overvaluation of highly distressed firms. The results are robust to alternative specifications of distress risk and mispricing measures.     

TRADING COSTS OF NON‐U.S. STOCKS ON THE NEW YORK STOCK EXCHANGE: THE EFFECT OF INSTITUTIONAL OWNERSHIP,ANALYST FOLLOWING,AND MARKET REGULATION

We investigate the differences in market microstructure between U.S. and non‐U.S. stocks cross‐listed on the New York Stock Exchange using a sample of 316 pairs of matched stocks. We find that non‐U.S. stocks have wider spreads and larger adverse‐selection costs than U.S. stocks even after controlling for macro‐level institutional differences. Regression analysis shows that spreads and adverse‐selection costs are negatively correlated with institutional ownership and analyst followings. Thus, the higher spreads and adverse‐selection costs for non‐U.S. stocks can be partly explained by the lower institutional ownership and analyst following of non‐U.S. stocks. In addition, we find that although the spreads and adverse‐selection costs for non‐U.S. stocks are significantly higher before the implementation of Regulation Fair Disclosure (FD), the differences become even greater after Regulation FD, suggesting that Regulation FD has improved the information environment for U.S. stocks.     

Tracking down distress risk

This paper shows that exposure to aggregate distress risk is the underlying source of the premiums for the Fama-French size (SMB) and value (HML) factors. Using a unique data set of aggregate business failures of both private and public firms from 1926 to 1997, I build portfolios that track news about future firm failures. These tracking portfolios optimally hedge aggregate distress risk and earn a Capital Asset Pricing Model (CAPM) alpha of approximately −4% a year. Both HML and SMB predict changes in future failure rates. Small stocks have lower returns than large stocks and value stocks have lower returns than growth stocks when the market expects an increase in future failure rates. Finally, a two-factor model with the market and the tracking portfolio for aggregate distress as factors does as well as the Fama-French three-factor model in pricing the 25 size and book-to-market sorted portfolios.     

Short Interest and Lottery Stocks

We find short interest‐related mispricing is strongest in lottery stocks. As stocks become more lottery‐like, arbitrage risk increases, resulting in higher overpricing (underpricing) in high (low) relative short interest (RSI) stocks. Monthly portfolio alphas are –1.61% for high RSI lottery stocks, whereas high RSI stocks with the least lottery‐like attributes show statistically insignificant alphas. Among lightly shorted stocks, lottery securities exhibit monthly alphas of 1.80%. Thus, although lottery stocks as a group typically underperform, investors can earn positive abnormal returns in lightly shorted lottery stocks. Our results suggest that lottery stocks’ greater noise trader risk and higher transactions costs impedes arbitrage in short interest‐related mispricing.