Does Short-Selling Amplify Price Declines or Align Stocks with Their Fundamental Values?

Abstract

Critics of short-selling argue that short-sellers amplify price declines by targeting firms with falling prices in an unwarranted manner. Contrary to this viewpoint, we find that increases in short-interest for firms following a price decline are associated with measures of overpricing based on financial statement analysis. Our results extend to short-selling activity following market-wide declines. We also find evidence consistent with the profitability of short-selling following price declines being driven by valuation-based positions. Overall, our findings suggest short-sellers primarily undertake valuation-based strategies following price declines and have implications for regulators. Limiting short-selling following price declines is likely to impede efficient price discovery.

Keywords: Short-selling, price declines, fundamental analysis, market regulation

JEL Classification: G12, G14, M41