Does short selling amplify price declines or align stocks with their fundamental values?

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 marketwide 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 History: Received June 7, 2011; accepted October 23, 2013, by Mary Barth, accounting. Published online in Articles in Advance April 4, 2014.
1. Introduction Regulators and academics generally agree that, when prices are rising, the activities of short sellers are beneficial to the economy. Short sellers are viewed as sophisticated investors who [...]