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Aggregate Short Interest and Market Valuations


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Aggregate Short Interest and Market Valuations
By OWEN A. LAMONT AND JEREMY C. STEIN*
The spectacular rise and fall of stock prices during the recent dot-com bubble period has been accompanied by a surge of interest in the topic of short-selling. For the most part, this work is cross-sectional in nature, examining the causes and consequences of short-sales con- straints at the individual-stock level, and it sug- gests the following two broad conclusions. First, consistent with the notion that short- selling is undertaken by rational arbitrageurs, the demand for short positions is greatest among stocks that appear to be overvalued (e.g., stocks that have high ratios of prices to book value). Second, because of frictions in the market for borrowing stock, as well as various institutional rigidities, arbitrage by would-be short-sellers is incomplete. Thus, those stocks where the de- mand for shorting is greatest (as measured, say, by a high premium paid to borrow the stock for the purposes of short-selling) tend to have ab- normally low future returns (see e.g., Patricia Dechow et al., 2001; Joseph Chen et al., 2002; Gene D’Avolio, 2002; Charles Jones and Owen Lamont, 2002; Lamont and Richard Thaler, 2003; Eli Ofek and Matthew Richardson, 2003).
Less attention has been paid to variation over time in aggregate short interest, and to the role that this might have in countering market-wide sentiment. Casual intuition might suggest that short-selling-based arbitrage would be more ef- fective along the aggregate dimension than it is in the cross section. After all, while it can be difficult at any point in time to short a minority of very overpriced stocks, most stocks are easily and cheaply shorted. Moreover, there are other ways to get a short bet down on the aggregate
* School of Management, Yale University, New Haven, CT 06520, and Department of Economics, Harvard Univer- sity, Cambridge, MA 02138, respectively. Thanks to the National Science Foundation for financial support, to Stefan Nagel and John Griffin for providing some of the data, to Andrea Frazzini and James David for research assistance, and to Harrison Hong, Charles Jones and Andrei Shleifer for helpful comments.
market—for example, by purchasing put op- tions on various indices.
It turns out that this intuition is off the mark. We examine some basic data on the evolution of aggregate short interest, both during the dot- com era, and at other times in history. In a striking contrast to the patterns seen in the cross section, total short interest moves in a counter- cyclical fashion. For example, short interest in NASDAQ stocks actually declines as the NASDAQ index approaches its peak. More- over, this decline does not seem to reflect a substitution away from outright short-selling and toward put options: the ratio of put-to-call volume displays the same countercyclical ten- dency. As we discuss below, the evidence is perhaps most consistent with Andrei Shleifer and Robert Vishny (1997), who argue that the open-end nature of most professional arbitrage firms (i.e., the fact that investors can withdraw their funds on demand) makes it difficult for these firms to buck aggregate mispricings. The evidence also suggests that short-selling does not play a particularly helpful role in stabilizing the overall stock market.
I. The Data
A. The Dot-Com Bubble
Figure 1 tells our basic story for the dot-com period. We plot three series on a monthly basis over the interval 1995–2002: (i) the NASDAQ index (the Center for Research in Security Prices [CRSP]’s total return index); (ii) the value-weighted short-interest ratio (100 times the market value of shares sold short, divided by the value of shares outstanding) for all NASDAQ companies; and (iii) the 60-day moving average of the Chicago Board Options Exchange’s (CBOE) daily put–call ratio. The put– call ratio is the total CBOE trading volume in puts (including both index options and op- tions on individual NASDAQ, NYSE, and AMEX stocks) divided by the volume in calls, and we use it as an admittedly noisy proxy for the
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