Short Selling Pressure, Stock Price Behavior, and Management Forecast Precision: Evidence from a Natural Experiment

Yinghua Li

Arizona State University (ASU) – School of Accountancy

Liandong Zhang

City University of Hong Kong

November 5, 2014

Journal of Accounting Research, Forthcoming


Using a natural experiment (Regulation SHO), we show that short selling pressure and consequent stock price behavior have a causal effect on managers’ voluntary disclosure choices. Specifically, we find that managers respond to a positive exogenous shock to short selling pressure and price sensitivity to bad news by reducing the precision of bad news forecasts. This finding on management forecasts appears to be generalizable to other corporate disclosures. In particular, we find that, in response to increased short selling pressure, managers also reduce the readability (or increase the fuzziness) of bad news annual reports. Overall, our results suggest that maintaining the current level of stock prices is an important consideration in managers’ strategic disclosure decisions.

Short Selling Pressure, Stock Price Behavior, and Management Forecast Precision – Introduction

Corporate executives pay considerable attention to secondary market prices and they have strong incentives to maintain or increase their firms’ stock prices. The accounting literature argues that managers can make strategic financial reporting or disclosure choices to influence stock prices (e.g., Healy and Palepu [2001]). A large body of empirical research examines whether and how corporate disclosures affect stock prices. The literature, however, provides little directional evidence on whether the behavior of stock prices has a causal effect on managerial strategic disclosure decisions. The difficulty in establishing causality stems largely from the endogenous nature of stock prices. In this paper, we use a natural experiment to examine the causal effect of stock price behavior on managers’ voluntary disclosure choices. Specifically, we examine the effect of an exogenous shock to short selling pressure and consequent price sensitivity to bad news on management forecast precision, where precision refers to the specificity of forecasts.

We focus on management forecasts and their precision for the following reasons. First, management forecasts are an important source of corporate financial information for investors. For example, Beyer et al. [2010] show that management forecasts provide, on average, approximately 55% of accounting-based information to the stock market over the 1994 to 2007 period. Thus, it is important to understand factors that affect management forecast choices. Second, there is a large degree of variation in forecast precision, and managers have a great deal of control and discretion over forecast precision (Hirst et al. [2008]). Once the decision to issue a forecast is made, managers can issue either qualitative or quantitative forecasts. Quantitative forecasts can be made as point, range, minimum, or maximum estimates. For range forecasts, managers can further choose their width. Due to litigation or reputation concerns, managers may have even greater discretion over forecast precision than over the decision of whether to issue a forecast (Cheng et al. [2013], Skinner [1994]). Thus, forecast precision is an ideal setting in which to test managers’ strategic disclosure choices. Finally, prior research shows that forecast precision has a significant effect on the sensitivity of market prices to forecast news (e.g., Baginski et al. [1993]). This effect makes the choice of forecast precision a natural fit in our controlled experiment, as discussed below.

Our experiment is based on Securities and Exchange Commission (SEC) Regulation SHO (Reg SHO), adopted in 2005. On September 7, 2004, the SEC passed Reg SHO, which mandated temporary suspension of short-sale price tests for a set of randomly selected pilot stocks during the period May 2, 2005 to August 6, 2007. The pilot stocks comprise every third stock of the Russell 3000 Index ranked by average daily trading volume. The suspension of short-sale price tests (i.e., the uptick test for the NYSE and the bid test for the NASDAQ) represents an exogenous decrease in short-sale constraints, leading to an increase in short selling activities for the pilot stocks (e.g., SEC [2007], Diether et al. [2009]). Increased trading activities of pessimistic investors make prices of the pilot stocks more sensitive to negative news (e.g., Goldstein and Guembel [2008], Grullon et al. [2012]).

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Short Selling

Short Selling