Short-sellers come in for a lot of criticism: individual investors don’t like the idea of someone benefiting from their loss and most of the finance industry has an incentive to promote optimism and the trade activity that comes along with it. They defend the practice by saying that short selling improves price efficiency, but a recent study suggests that too much short pressure causes management to reduce precision of negative forecasts so that everyone has less relevant information to work with.
“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,” write Arizona State University associate professor Yinghua Li and City University of Hong Kong associate professor Liandong Zhang in their paper Short Selling Pressure, Stock Price Behavior, and Management Forecast Precision: Evidence from a Natural Experiment.
Using Reg SHO testing as an experiment for other hypotheses
It’s one thing to say that c-level executives are aware of and influenced by the market, but it’s hard to decouple that from all the other pressures that they face. But Li and Zhang had the idea of going back to the Regulation SHO tests in 2005 as a natural experiment. To test the need for short selling restrictions, the SEC removed the uptick rule (which only allows short sales to be filled on a price uptick) for one third of Russell 3000 stocks chosen at random to see what would happen. In 2007 the SEC decided that it was safe to scrap the uptick rule, but reinstated a modified form in 2010 after deciding that it may have contributed to big price plunges during the financial crisis.
Li and Zhang aren’t revisiting the uptick rule, but this does give them a clear case where one group of stocks potentially face more short pressure than another because of clear regulatory differences. They looked for changes in CFO/CEO disclosures in the SEC’s test group, using the remaining 2000 stocks as a control. Executives have limited discretion on how they forecast future performance, since there could be legal and reputational consequences for unjustifiable forecasts, but they have a lot of discretion over the precision of those forecasts, opting to give a maximum, minimum, range, or point value target to analysts. So the research looked for changes in precision, where executives have the most discretion, to show that short pressure impacts their choices.
Short pressure: Precision of bad news fell 17%
The researchers found that executives did reduce precision when delivering bad news by an average of 17%, but not right away. The changes were more pronounced in the second year than they had been in the first (the SEC test lasted eight quarters), implying that management was adjusting its behavior to the regulatory changes gradually instead of anticipating the need to obfuscate bad news when the Regulation SHO tests were first announced.
Additionally, the Reg SHO tests didn’t impact positive news announcements or the accuracy of announcements (good or bad), only the precision of bad news changed significantly. There weren’t strong correlations with industry or size, but there was one other correlation that points to the role of discretion to change language: CFO’s whose compensation was most sensitive to stock prices were also the most likely to change behavior.
See full study here.