Why do firm fundamentals predict returns? Evidence from short selling activity |
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| Institution: | 1. Cardiff Business School, Colum Drive, University of Cardiff, Cardiff CF10 3EU, UK;2. Bradford Management School, Bradford University, Richmond Road, Bradford BD7 1DP, UK;1. Urban Institute, Kyushu University, Fukuoka, Japan;2. Energy Studies Institute, National University of Singapore, Singapore;3. Stern School of Business, New York University, New York, USA;1. School of Economics, Beijing Technology and Business University, China;2. College of Economics and Management, China Agricultural University, China |
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| Abstract: | This study uses short selling activity to test whether the relation between fundamentals and future returns is due to rational pricing or mispricing. We find that short sellers target firms with fundamental performance below market expectations. We also show that short selling activity reduces the return predictability of fundamentals by speeding up the price adjustments to negative fundamental signals. To further investigate whether the returns earned by short sellers reflect rational risk premia or mispricing, we exploit a natural experiment, namely Regulation of SHO, which creates exogenous shocks to short selling by temporarily relaxing short-sale constraints. Evidence from the experiment confirms that the superior returns to short sellers result from exploiting overpricing. Overall, our study suggests that the return predictability of fundamentals reflects mispricing rather than rational risk premia. |
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