Divergence of opinions, short sales, and asset prices
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Prior research has established that stocks with high dispersion of earnings forecasts or short interest are associated with low subsequent returns. Assuming dispersion of forecasts is a proxy for divergence of opinions and short interest is a proxy for short selling constraints, these results have been traditionally attributed to correction for overpricing created by binding short selling constraints. This argument is provided by Miller (1977), and states that prices reflect an optimistic view when investors with pessimistic views can not trade due to short selling constraints, and that the more opinions diverge, the more stocks become overpriced. I test whether dispersion of forecasts exacerbates overpricing, but find evidence contrary to Miller’s theory. When dispersion of forecasts increases, prices decrease. I offer an explanation based on analysts’ reluctance to quickly revise their forecasts downward. I show that some analysts’ sluggish response to bad news results in dispersion of forecasts. The inertia in downward forecast revisions also leads to market underreaction to bad news. Therefore, the negative relationship between dispersion and subsequent returns may be attributable to analysts’ sluggish response to bad news. I also examine the return predictability of firms with high short interest and low institutional ownership. Short interest seems to predict not only future stock returns but also future earnings news, especially for firms with lower institutional ownership. Therefore, the return predictability of short interest seems to be associated with value relevant information short sellers seem to have gathered.
Erturk, Bilal (2006). Divergence of opinions, short sales, and asset prices. Doctoral dissertation, Texas A&M University. Available electronically from