Why Do Short Interest Levels Predict Stock Returns?

Abstract

High levels of short interest predict negative abnormal returns, but the reasons for this predictability are not well understood. Moreover, two popular explanations suggest very different interpretations. According to Miller (1977), stocks are overvalued in the presence of short-sale constraints and the subsequent negative abnormal returns represent a correction of this overvaluation. In contrast, Diamond and Verrecchia's (1987) information-based explanation does not presume that stocks are mispriced. Instead, short-sellers are regarded as traders who have information about future returns. We discriminate between the two explanations and find support for the information-based explanation. Therefore, our evidence suggests that short sellers incorporate value-relevant information into prices.

Keywords: Short selling, short interest, overvaluation, stock returns

JEL Classification: G12, G14