Short Sellers, Persuasion Games, and Predicting the 'V'

Abstract

In a noteworthy recent paper, Mitts (2020) presents empirical evidence that published attacks on publicly-traded companies by certain presumed short-sellers generate “V”-shaped pricing patterns, whereby targeted companies’ stock prices fall precipitously when a negative report is published, but later substantially rebound. Mitts associates these dynamics with manipulative practices by the reports’ authors and their confederates. In a recent response, Block (2022) criticizes Mitts (2020) on several fronts (both academic and otherwise), taking particular issue with the fact that the “V” emerges out of a data restriction imposed by Mitts (2020), whereby issuers with less than $2 billion in market capitalization were excluded from the baseline analysis. When one introduces smaller size cutoffs, the empirical effect dissipates. This note develops a theoretical model to study the valuation of financial assets in the presence of short sellers who may issue false reports about targeted companies, as well as targeted companies who may choose to fight back. I derive equilibria of the model, and show that (a) “V”-shaped pricing paths for targeted firms can (and do) emerge along the equilibrium path; (b) when they emerge, such paths are symptomatic of an inaccurate report; (c) “V”-shaped paths are always part of a unique equilibrium for “large” firms; and (d) “V”-shaped paths are never part of a unique equilibrium for “small” firms. Jointly, these results provide theoretical support and a helpful interpretive lens for Mitts (2020)’s data restriction and findings. At the same time, the model also predicts that “V”-shaped patterns for wrongly-attacked firms would be difficult to discern from aggregated market data that was generated via equilibrium play. Consequently, additional research is needed to assess whether the sub-groups analyzed by Mitts (2020) constitute a sufficiently diagnostic screen to pinpoint manipulative practices.

Keywords: short selling, activism, market regulation, finance, law, trading, manipulation, 'short and distort'

JEL Classification: G14, K22