Short-sellers trade on accounting information, not price declines

Short-sellers get a bad rap.

These audacious investors—who profit when stock prices fall—make a convenient scapegoat for market crashes and frequently draw the ire of regulators and pundits for allegedly speeding the demise of perfectly good companies.

But a new study by Asher Curtis, an assistant professor of accounting at the University of Washington Foster School of Business, finds that short-sellers trade on comprehensive analysis of public accounting information rather than the trajectory of stock prices.

And while they make their bones betting on losers, short-sellers introduce liquidity and bring overpriced stocks closer to their fundamental values. This is good for financial markets—even when prices are falling.

“It’s appropriate for investors to make markets more efficient by moving stock prices closer to their fundamentals,” Curtis says. “Though it may appear like short-sellers are chasing downward prices, we find that they are actually using accounting information to find companies that just aren’t as valuable as their market price would suggest.”

Bad reputation

Often part of a hedge-fund strategy, short-sellers borrow shares in companies whose market value, they believe, is likely to decline. They make money by selling high and buying back low, before returning the shares according to the terms of their contract.

Short-selling involves considerable risk. Prices can drop only to zero, but they can rise indefinitely. And any rise is moving against the short-seller’s interest. In exchange for this risk, successful short-sellers can extract a hearty return.

Why are they so vilified? Curtis believes that the reputation of short-sellers has been sullied by the few cases of traders who have disseminated rumors or promoted negative information in an effort to drive a firm’s price down. But the vast majority are simply diligent investors who scour financials to spot trouble ahead, then exploit it for profit.

Even regulators have come to see the role of short-sellers in rooting out overpriced firms as a positive when their prices are climbing. An over-inflated stock works against market efficiency. And we know how messy things can be when bubbles burst.

Yet those same regulators have the opposite opinion of short-sellers when their target firm’s stock—or the entire market—is trending downward. In those instances, they hold that negative investors are cashing in on a firm’s fall, and even accelerating its downward momentum. These concerns intensify during market crashes.

Information over price

To find out whether short-sellers use accounting information or price declines, Curtis and co-author Neil Fargher of Australian National University examined the positions of short-sellers from 1995 to 2011, a period that spans both significant regulatory change and the recent financial crisis.

They compared trading behavior with the trajectory of individual target and market-wide stock prices and the fundamental values of those stocks via a comprehensive analysis of firm financials.

Though they noted significant short-interest following price declines, it was concentrated in firms that appear to have been overpriced based on clues in their financial statements—low fundamentals-to-price ratios, high accruals, high asset growth, among other signals.

A battery of tests arrived at the same conclusion: short-sellers were using information, not price, to determine their investment targets. Whether the stocks were trending up or down was immaterial.

“We found consistently that short-sellers target those stocks that have low fundamental values relative to their current market prices,” Curtis says.

Fiscal double standard

This may come as news to regulators, who have long attempted to curtail the activities of short-sellers when prices are falling.

The Securities and Exchange Commission, for example, issued a temporary ban on short-selling of nearly 800 financial firms in fall of 2008. And in 2010 the SEC restricted short-selling activity when a firm’s price declines by ten percent or more in a single trading day.

Curtis calls it a double standard to endorse short-selling for correcting overpriced firms, except when their price is already declining.

“It’s a strange inconsistency,” he says. “Regulators approve of short-sellers when stock prices are rising. But when they are declining, they must be doing something wrong.”

Curtis suggests that the SEC and other financial regulators look past the pejorative stereotypes when regulating short-selling activity in declining markets. The data doesn’t support this view.

“Although these positions may appear to push prices down below fundamental values on the surface,” he says. “the evidence suggests the opposite: that the positions of short-sellers among firms with prior price declines are concentrated within overpriced firms on average.

“Regulations restricting the actions of short-sellers may impede efficient price discovery for firms trading above their fundamental values.”

“Does Short-Selling Amplify Price Declines or Align Stocks with Their Fundamental Values?” is forthcoming in the journal Management Science.