Short selling and the price discovery process

We show that stock prices are more accurate when short sellers are more active. First, in a large panel of NYSE-listed stocks, intraday informational efficiency of prices improves with greater shorting flow. Second, at monthly and annual horizons, more shorting flow accelerates the incorporation of public information into prices. Third, greater shorting flow reduces post-earnings-announcement drift for negative earnings surprises. Fourth, short sellers change their trading around extreme return events in a way that aids price discovery and reduces divergence from fundamental values. These results are robust to various econometric specifications, and their magnitude is economically meaningful.

That is from 2013 research by Boehmer and Wu.  Next, beware of any paper doing cross-sectional comparisons across 111 countries, but here is how the resulting correlations go (link):

We find that when short-selling is possible, aggregate stock returns are less volatile and there is greater liquidity. When countries start to permit short-selling, aggregate stock price increases, implying lower a cost of capital. There is no evidence that short-sale restrictions affect either the level of skewness of returns or the probability of a market crash. Collectively, our empirical evidence suggests that allowing short-selling enhances market quality.

While I would not draw very firm conclusions from that, it is not going to help the case against short-selling.  Here is a general literature survey from 2020.  Lots is murky, but again the evidence is not supporting the often rather polemic critics.  A very general point is that short selling is less different from “plain selling” than you might think, all the more so if you consider dynamic portfolio strategies (which can replicate just about any underlying desired net position).

Furthermore, these days there is more choice than ever before.  If the asset you have in mind is somehow too fragile to withstand short-selling pressure, but is valuable nonetheless, staying private never has been easier and with some degree of liquidity to boot.


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