Short Interest and Aggregate Stock Returns

Abstract

We show that short interest is arguably the strongest known predictor of aggregate stock returns. It outperforms a host of popular return predictors both in and out of sample, with annual r-squared statistics of 12.89% and 13.24%, respectively. In addition, short interest can generate utility gains of over 300 basis points per annum for a mean-variance investor. A vector autoregression decomposition shows that the economic source of short interest’s predictive power stems predominantly from a cash flow channel. Overall, our evidence indicates that short sellers are informed traders who are able to anticipate future aggregate cash flows and associated market returns.

The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2675298

Keywords: Equity risk premium; Predictive regression; Short interest; Asset allocation

JEL Classification: C58, G12, G14