Short Sellers Tend To Be Smart MoneyMark W. Gaffney
Today's investors are bombarded with a never ending stream of news and information on equity markets. But what if nearly all information was somehow cut off, and you had only one predictive indicator for deciding which stocks to buy or sell? What would you choose? Which of the following is most predictive of a stock’s future returns?
- Price-to-earnings ratio
- Price-to-book ratio
- Dividend yield growth
- Moving averages
- RSI and stochastics
- Put-call ratios
- Short interest ratio
Probably not many investors would choose “g”, short interest ratio. But according to a number of academic studies, short interest is the most predictive indicator of equity returns, both at the individual and aggregate level.
A stock’s short interest is the quantity of shares that investors have sold short but not yet covered or closed out. A stock’s short interest ratio refers to the number of shares sold short as a percentage of the stock’s float or shares that trade freely.
For U.S. markets, the short interest of individual stocks is updated monthly. Short interest reflects a combination of shares sold short by individuals, professionals and institutions. You can find data regarding the short position in a stock at Nasdaq.com, the New York Stock Exchange and other publications and subscription services.
One might think that the higher a stock’s short interest, the more likely its price is to rise. This would be a logical assumption, because to close a short position, a short seller must buy the short shares back. So, a large short position could be seen as representing pent-up buying demand for a particular stock, or in aggregate, for the overall market.
However, empirical research does not support this line of reasoning. The fact is that high short interest has been found to be predictive of the underperformance of securities, both individually and in aggregate. The higher short interest is, the more likely a stock or market is to deliver relatively poor returns in the months following.
2016 research report: Short interest is arguably the strongest known predictor of aggregate stock returns.
In a 2016 report entitled “Short Interest and Aggregate Stock Returns,” Rapach, Ringgenberg and Zhour found that: Short interest is arguably the strongest known predictor of aggregate stock returns. The authors compared the predictive ability of aggregate short interest (the total short interest of U.S. stocks) to other popular predictors of stock prices, like: Dividend-price ratio; dividend yield; earnings-price ratio; dividend-payout ratio and excess stock return volatility, etc.
The authors found that short interest “...outperforms a host of popular return predictors both in sample and out of sample, with annual R2 statistics of 13% and 11%, respectively. In addition, short interest can generate utility gains of over 300 basis points per annum for a mean?variance investor.”
Also, while many popular stock performance predictors exhibit strong correlations with each other, the study showed short interest to be largely unrelated to other predictors. In other words, short interest appeared to contain substantially different information from other data used to predict future stock performance.
Here is a brief summary of studies pertaining to short interest of individual securities:
- Short interest predicts future bad news, negative earnings surprises, and downward revisions in analyst earnings forecasts. This informational content is stronger for stocks that are harder to short...Our results suggest that short interest predicts future returns, in part, due to short sellers’ ability to uncover unfavorable information about firms. Ferhat Akbas, Ekkehart Boehmer, Bilal Erturk, Sorin Sorescu, 2016
- Abnormal short interest increases steadily in the 19 months before the misrepresentation is publicly revealed, particularly when the misconduct is severe...These results indicate that short sellers anticipate the eventual discovery and severity of financial misconduct. Jonathan M. Karpoff, Xiaoxia Lou, 2010
- Heavily shorted stocks underperform lightly shorted stocks by a risk-adjusted average of 1.16% over the following 20 trading days (15.6% annualized). Institutional short sales are the most informative; stocks heavily shorted by institutions underperform by 1.43% the next month (19.6% annualized). Ekkehart Boehmer, Charles M. Jones, Xiaoyan Zhang, 2008
The studies agree: Short sellers possess an information advantage regarding future earnings and cash flows. In other words, short sellers are informed traders. And not only are they skilled at processing firm-specific information, but taken in aggregate, are also good predictors of broad market performance.
U.S. Stocks with highest short positions as a percentage of float. As of 10-31-17.
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What might explain why high short interest is predictive of equity underperformance?
It’s important to appreciate the difficulties and risks inherent in shorting vs buying and holding. Short sellers must borrow stock in the equity lending market to initiate their trades, and shares aren’t always available. The loan fees for holding short positions can be high, and may rise unpredictably. Regulations require short sellers to post significant capital. So the costs associated with holding a short position are greater than holding long positions -- short returns must be greater to compensate for the additional costs.
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Also, the risks of holding a short position can be greater. Short sellers are subject to unusual but potentially adverse “short-squeezes,” whereby a heavily shorted stock moves sharply higher, forcing more short sellers to close out their short positions and adding to the upward pressure on the stock. In a severe short-squeeze a short seller may be “squeezed” out of a position, and forced to sell at a loss.
Investors who initiate large short positions in the face of these elevated costs and risks do not do so casually -- they have likely conducted extensive research. So, stocks with large short interest tend to reflect the opinions of sophisticated investors that have spent substantial time and money assessing the prospects of a given company. A large short interest position in a stock can be seen as a collective vote by informed “smart money” short sellers that the shares of a company are overvalued.
The bottom line is that short sellers tend to unearth information about public companies that other investors are unaware of or have turned a blind eye to. Large short interest in a stock typically reflects professional short sellers placing large bets that their bearish views are correct. The implication of this is clear: Devoting a portion of one’s portfolio to short strategies can provide a valuable hedge to long equity holdings. And replicating the actions of the best short sellers can make you a lot of money.
In the pages that follow we’ll delve into the world of top activist short sellers -- contrarians who have generated large profits for themselves, their investors and their followers. As investment markets bubble ever higher, and irrational exuberance increasingly separates stock prices from reality, studying and emulating the great short sellers and their campaigns makes more sense than ever.
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