While individual investors may pour money into the hot stock of the moment and pull it back out at the first time of trouble, short-selling is still mostly the domain of sophisticated investors, so when a stock’s short-interest ratio (SIR) starts going up there’s good reason to start looking for problems. But it turns out that the supply of lendable shares often constrains the market, keeping SIR at low levels even when actual short interest is high.
“Even in the most liquid equity market in the world, the pool of readily borrowable shares can be a frequently binding constraint to informational arbitrage,” write M.D. Beneish, C.M.C. Lee, and D.C. Nichols in their recent paper In Short Supply: Short-Sellers and Stock Returns.
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Supply constraints keep SIR low when stocks are overpriced
Using data from more than 100 institutional lenders spanning from 2004 to 2013, the researchers were able to put together an aggregate view of a market that’s been hard to analyze because of the lack of a centralized clearinghouse. They found that on average, stocks have about 20% of outstanding shares readily available for lending at any one time, but the with a lot of variation from stock to stock, and falling to 10% is enough to create a supply constraint in many situations.
Borrowing costs are higher for small-caps, high volatility stocks, and stocks with recent negative returns, all of which seems pretty clear. Borrowing costs also go up when the level of institutional ownership is low or the stock price is low, presumably because it’s harder to coordinate lending of these cheap stocks in the OTC market, or when stocks seem overpriced.
“Both borrow costs and the supply of lendable shares, are impacted by the accounting characteristics associated with pricing anomalies. In general, borrow costs are higher when these characteristics indicate the firm is overvalued,” write Beneish, Lee, and Nichols.
In other words, when a fundamental investor would be most interested in shorting a stock, there won’t be enough supply to go around and the borrowing costs might be too high to go through with the deal, and SIR will remain low even despite a change in sentiment. In some cases, they found that an SIR of just 5% could signal a nearly full utilization.
Policymakers shouldn’t impede short selling
Beneish, Lee, and Nichols also found that a shortage in lendable shares impairs price efficiency because negative sentiment isn’t being expressed in the way that other market participants expect, and therefore isn’t getting priced in. Lots of people have a knee-jerk, anti-short bias, but they argue that policy makers should be careful not to limit the supply of lendable shares (intentionally or unintentionally) or they risk inflating stock prices and setting investors up for a sharp correction.