Journal of Banking and Finance 108 (2019) 105617

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Journal of Banking and Finance

journal homepage: www.elsevier.com/locate/jbf

Short interest, stock returns and credit ratings

Xu Guo a, Chunchi Wu b,∗
a
118 Administration Building, Center for Economics, Finance and Management Studies, Hunan University, Changsha, Hunan Province, 410006, China
b
335A Jacobs Management Center, School of Management, State University of New York at Buffalo, Buffalo, NY 14260-4000, USA

a r t i c l e i n f o a b s t r a c t

Article history: This paper investigates the role of credit risk in the relationship between short-selling activity and future
Received 8 November 2018 stock returns. We find that the predictive power of short interest for future returns is concentrated in
Accepted 29 August 2019
the worst-rated stocks. Low-grade stocks with the largest short interest decrease outperform those with
Available online 30 August 2019
the largest short interest increase by 1.09 percent in the following month. This return spread is robust
JEL classification: to controls for cross-sectional effects and firm characteristics, and is much more pronounced during pe-
G12 riods of high investor sentiment and low liquidity. Distressed firms with large short interest increases
G13 experience a worse performance subsequently.
© 2019 Elsevier B.V. All rights reserved.
Keywords:
Short interest
Return predictability
Financial distress
Credit ratings
Anomaly

1. Introduction
Short-selling activities have witnessed rapid growth in recent
decades, and the role of equity short interest in asset pricing
has attracted considerable attention from academics. The litera-
ture has documented a negative cross-sectional relationship be-
tween short interest levels and future stock returns (Desai et al.,
2002; Diether et al., 2009; Boehmer et al., 2010).1 At the same
time, it has been shown that financial distress has a substan-
tial effect on the cross-section of expected asset returns (Vassalou
and Xing, 2004; Avramov et al., 20 07, 20 09a, 2013; Jostova et al.,
2013). In a dynamic asset pricing equilibrium, prices, volume and
short interest ratios are determined simultaneously. Given the ev-
idence that market anomalies appear to concentrate in a universe
of low credit quality firms and during deteriorating credit peri-
ods (Avramov et al., 2013), it is important to explore the rela-
tions between stock returns, short interest and credit ratings. Like
other anomalies, the short interest effect may be a manifestation
of credit risk effect.
This paper contributes to the current literature by investigat-
ing the predictability of short interest for future returns of stocks
with different ratings to assess the implications of financial dis-
∗
Corresponding author.
E-mail addresses: xuguo@hnu.edu.cn (X. Guo), chunchiw@buffalo.edu (C. Wu).
1
Short interest anomaly also occurs in other markets (Kecskés et al., 2012; Henry
et al., 2015; Griffin et al., 2016).
tress for the short interest anomaly. We are particularly inter-
ested in the role of firm-level distress risk in the cross-section
of stock returns. We employ the measure of changes in short
interest to better capture variations in short-sellers’ beliefs. Our
preference for using this measure is motivated by the finding of
Rapach et al. (2016) that short interest exhibits a trend and short
interest changes are a better proxy for time-varying short-sellers’
beliefs that drive stock returns.
A number of studies have examined the role of finan-
cial distress in asset pricing. Fama and French (1996) suggest
that size and value factors proxy for financial distress, and
Vassalou and Xing (2004) provide evidence to support this argu-
ment. Friewald et al. (2014) and Anginer and Yıldızhan (2018) doc-
ument a positive relation between expected stock returns and dis-
tress risk. They show that firms with high credit risk premia have
high subsequent equity returns. Avramov et al. (2007) provide evi-
dence that stock momentum concentrates on distressed firms and
Avramov et al. (2009a) find that financial distress explains the
anomaly of trading strategies based on analyst forecast dispersion.
In a comprehensive study, Avramov et al. (2013) show common-
alities across asset pricing anomalies in the stock market, and the
firm-level distress risk characteristic explains most of the abnor-
mal returns in many anomaly-based trading strategies in the stock
market such as price momentum, earnings momentum, credit risk,
analyst earnings forecast dispersion, idiosyncratic volatility, capital
investments, and book-to-market anomalies. However, this study
does not cover the short interest anomaly. This omission raises an

https://doi.org/10.1016/j.jbankfin.2019.105617
0378-4266/© 2019 Elsevier B.V. All rights reserved.
2 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617
intriguing question of whether the distress effect also plays a role
in the short interest anomaly.
Distressed firms are quite different from other firms. When
firms are in financial distress, uncertainty about their fundamen-
tals rises dramatically. Financial distress affects firms’ future per-
formance through complicated channels such as bond covenant
violations, regulatory restrictions, and deterioration in customer,
creditor, supplier and employee relations. Deteriorating firm condi-
tions typically lead to a rating downgrade and depression of stock
prices. These adverse effects are difficult to overcome, but if the
management is able to steer a turnaround, stock values can bounce
back sharply. The drastic stock price movement surrounding a rat-
ing downgrade and high sensitivity of distressed stock returns to
earnings present an excellent opportunity for informed investors to
exploit their private information. This rationale provides a plausi-
ble explanation for why anomalies are concentrated in high credit
risk firms.
Using credit ratings as an ex-ante indicator for a firm’s future
performance, we investigate the predictive power of short inter-
est changes for stock returns of firms in different rating categories.
Consistent with the literature, we find that a high (low) short in-
terest level is associated with a low (high) future stock return. Im-
portantly, we uncover new evidence that the return predictability
of short interest levels is concentrated in distressed firms. More-
over, we find that changes in short interest have higher predictive
power for future stock returns of distressed firms than the level of
short interest. This finding suggests that changes in short interest
are better proxies for changes in short-sellers’ beliefs and hence
provide a more reliable signal for future stock performance.
The return predictability associated with short interest changes
is of economic significance. Stocks with a large increase (decrease)
in short interest experience low (high) returns subsequently, and
a portfolio that longs stocks with the most negative change in the
short interest ratio (P1) and shorts stocks with the most positive
change (P10) generates a 14.6% annualized risk-adjusted return for
financially distressed firms. This return spread is robust to control-
ling for various cross-sectional effects and firm/stock characteris-
tics. However, the return gap between high and low short inter-
est stocks may not be exploitable. Overpricing may not be arbi-
traged away due to costly short selling and risky arbitrage for high
credit risk stocks, which are difficult to value and arbitrage (see
Stambaugh et al., 2012; Avramov et al., 2017).
Empirical evidence suggests that aggravation in short interest
signals poor future firm performance, while extenuation predicts
positive future performance. This finding is consistent with the
contention that short sellers have superior value-relevant informa-
tion for firms’ future performance and their trading activities con-
vey this information. Short-sellers’ information advantage appears
to be most acute for financially distressed firms. Financial distress
leads to sharp responses in stock prices and informed short sell-
ers are able to seize this opportunity to maximize their informa-
tion advantages. Thus, while investors can gain from exploiting
short interest information, the short interest anomaly is more pro-
nounced among stocks of financially distressed firms.
Further analysis of the economic source of the short interest
anomaly reveals that changes in short interest contain informa-
tion for a firm’s future profitability. We find that short interest
changes signal future operating performance of distressed firms.
At the same time, stock returns of distressed firms are sensitive
to changes in corporate earnings. The high sensitivity of returns to
firms’ profitability increases the value of short-sellers’ private in-
formation, which in turn increases the profitability of short selling
distressed stocks. While we find that short interest changes convey
information about the future operating performance of distressed
firms, we note that the information content of credit ratings is
likely more complicated. In particular, the literature has suggested
that credit ratings contain information about uncertainty for firms’
future fundamentals, growth rates and cost of capital, mispricing,
limited future access to credit, and information uncertainty due to
fewer analysts following (see, for example, Avramov et al., 2009a,
2013, 2017; Akbas et al., 2017).
The predictive power of short interest for future stock returns
varies across firms of different characteristics. The long-short port-
folio return is higher for firms with small capitalization, high lever-
age, low trading volume, high analyst forecast dispersion, and low
institutional ownership. While the predictive power of short in-
terest for future stock returns varies with firm characteristics, the
short-selling effect is not subsumed by any effects of these char-
acteristics. The effect of short interest changes persists even after
controlling for these characteristics. Results strongly suggest that
short interest has independent predictive power for future stock
returns of distressed firms over and beyond the usual predictors in
the stock market.
Our work is related to two important papers on short sell-
ing and credit risk. First, Drechsler and Drechsler (2016) find that
shorting fees are a strong predictor of the cross-section of stock
returns. They document a significant shorting premium for the
portfolio that longs the stocks with the lowest shorting fee and
shorts the stocks with the highest shorting fee, and interpret this
premium as a compensation for the concentrated risk that arbi-
trageurs bear in shorting overpriced stocks. While Drechsler and
Drechsler (2016) uncover the first evidence on the premium earned
for shorting high short-fee stocks, our work complements their
study by attempting to understand the source of that premium.
Second, Avramov, Chordia, Jostova, and Philipov (2017) find that
anomalies among both stocks and bonds extract their profitability
primarily from the intersection of firm-level credit risk and market
sentiment. Their finding suggests that the credit risk effect is at-
tributable to sentiment-driven investors who underestimate the se-
vere implications of financial distress for a firm’s future prospects,
and that short sellers capitalize on this sluggish response. Consis-
tent with their finding, our results are closely linked to market
sentiment in that the predictive power of short interest for future
stock returns is much stronger in periods of high sentiment.
2. Data
Our main data source is Compustat database, which provides
stocks’ monthly short interest levels beginning in 1973. We merge
the short interest data with data from the Center for Research in
Security Prices (CRSP) by the cusip number. Each stock’s short in-
terest level is divided by its total shares outstanding to obtain the
short interest ratio (SIR). Following Rapach et al. (2016), we drop
observations with stock prices below $5 per share and firms with
market value below the fifth percentile of NYSE market capitaliza-
tion using the breakpoints from Kenneth French’s website. This fil-
tering ensures that our results are not driven by small and illiq-
uid stocks. Our sample covers stocks listed in NYSE, NASDAQ and
AMEX (shrcd = 10 or 11, exchcd = 1, 2 or 3).
When the change in short interest ratio SIRit is positive, the
amount of stock i being shorted is higher than the amount of stock
covered in month t. If the main reason for short selling is to exploit
the overpricing of stocks, the magnitude of SIRit should be a bet-
ter proxy for stock overvaluation than the short interest level. We
therefore use SIRit as a predictor for future stock returns, but for
robustness we also report results based on the short interest level.
We use the S&P credit ratings, which are available monthly
from 1986. The credit rating reflects the agent’s opinion of the is-
suer’s overall creditworthiness, apart from its ability to repay in-
dividual debt obligations. We merge the ratings with the short
interest ratio data by gvkey. The merged sample includes 2792
stocks and 301,868 stock-month observations over the period from
 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617 3

Table 1
Summary statistics.

Rating Numerical ID Rating group Period 1 Period 2 Number of observations Percent of total observations

Panel A: sample breakdown by rating

AAA 1 IG 2,764 1,365 4,129 1.37%
AA+ 2 1,540 380 1,920 0.64%
AA 3 5,868 2,078 7,946 2.63%
AA- 4 5,534 3,244 8,778 2.91%
A+ 5 8,932 8,147 17,079 5.66%
A 6 14,887 15,234 30,121 9.98%
A- 7 10,940 13,638 24,578 8.14%
BBB+ 8 10,859 18,681 29,540 9.79%
BBB 9 11,889 26,716 38,605 12.79%
BBB- 10 8,505 21,076 29,581 9.80%
BB+ 11 NIG 6,251 14,046 20,297 6.72%
BB 12 6,815 17,824 24,639 8.16%
BB- 13 7,082 20,272 27,354 9.06%
B+ 14 7,065 14,752 21,817 7.23%
B 15 1,389 8,805 10,194 3.38%
B- 16 550 3,317 3,867 1.28%
CCC+ 17 234 759 993 0.33%
CCC 18 171 157 328 0.11%
CCC- 19 34 13 47 0.02%
CC 20 4 51 55 0.02%
C 21 0 0 0 0.00%
Total 111,313 190,555 301,868 100.00%

Distribution of stock returns by credit rating (CR) deciles

CR1 CR2 CR3 CR4 CR5 CR6 CR7 CR8 CR9 CR10
1.03 1.12 1.10 0.83 1.13 1.05 1.03 1.12 0.88 0.83

Panel B: distribution of SIR and SIR

Mean Std Median Min. Max. Skewness Kurtosis

SIRit (%) 3.56 4.71 1.92 0.00 100.00 3.55 25.84
SIRit (%) 0.02 1.18 0.00 -88.94 89.31 1.91 526.90

Panel A presents the composition of the sample of firms that are rated by S&P and have short interest data in Compustat. We exclude stocks with an average price below
$5 or firms with market capitalization below the fifth percentile breakpoint of NYSE market capitalization, using the breakpoints from Kenneth French’s website. We assign
a numerical indicator to each rating in column 2 and group the sample firms into 2 rating categories in column 3: investment grade (IG) and non-investment grade (NIG).
We also report observations for two subperiods (1 & 2), for which the dividing point is December 20 0 0. We use these data for our subperiod analysis later. At the bottom
of Panel A, we sort the sample into deciles (CR1 to CR10) by rating and report the returns for these decile portfolios. Panel B provides summary statistics of the level and
changes of short interest, SIRit and SIRit . The full sample period runs from January 1986 to February 2017.

January 1986 to February 2017. In subsample analysis, we divide
stocks into investment grade (IG) and non-investment grade (NIG)
groups.
Table 1 presents our summary statistics. The NIG group con-
tains 36.30% of all stock-month observations. For the IG group, BBB
stocks have the highest proportion of total observations, which is
32.38%, followed by A (23.78%), AA (6.18%) and AAA (1.37%). When
dividing the sample into two periods using December 20 0 0 as a di-
viding point, the second period includes more observations, which
is attributable to investors’ easier access to the equity lending mar-
ket and an increase in the number of hedge funds. The sample size
increase in the later period is mainly due to more firms with a
rating of BBB+ and lower. The bottom of Panel A reports returns
of decile portfolios sorted monthly by credit rating. Monthly re-
turns are 1.03% for the highest decile (CR1) and 0.83% for the low-
est decile (CR10). This return pattern is dubbed the credit puzzle in
the literature (e.g., Avramov et al., 2009b). Panel B of Table 1 shows
the distribution of SIR and SIR. The mean value is 3.56% for SIR
and 0.02% for SIR. There is high dispersion in SIR ranging from
-88.94% to 89.31%.
3. Empirical results
3.1. Credit ratings and short interest level/change
In each month t, we sort stocks into decile portfolios by SIRit
or SIRit . For portfolio sorts by short interest level, P1 consists of
the most lightly shorted stocks and P10 contains the most heavily
shorted stocks. For the portfolio analysis by short interest changes,
P1 includes the stocks with the largest decrease (most negative
change) in the short interest ratio in month t, and P10 includes
the stocks with the largest increase (most positive change) in the
short interest ratio.
We assign a numerical indicator to each rating (see column 2
of Table 1) and report the average rating score for each decile
portfolio. Panel A of Table 2 reports the ratings for decile port-
folios sorted by short interest level. The results show that lightly
shorted stocks have higher ratings than heavily shorted stocks.
The rating score of P1 is 8.47 (between BBB and BBB+) and it
increases to 11.86 (BB) for P10. Panel B shows the decile portfo-
lios sorted by short interest changes. The average rating score is
10.39 (BBB-) for P1, gradually decreases to 8.51 (between BBB and
BBB+) for P5, and then bounces back to 10.52 (BBB-) for P10. The
rating distribution thus exhibits a U-shape with both P1 and P10
tilted towards low rated stocks. In both panels, portfolio returns
trend downward from P1 to P10 with a clearer monotonic pat-
tern for the NIG subsample. In contrast, the mispricing measure
of Stambaugh et al. (2015) shows no clear monotonic pattern.
Panels C and D of Table 2 report firm characteristics for decile
portfolios sorted by short interest level and changes, respectively.
Equity volatility is the standard deviation of stock returns over the
past six months and idiosyncratic volatility is the standard devi-
ation of daily stock return residuals relative to our baseline factor
model over the past five years. For SIR sorts, there is a monotonic
pattern for institutional ownership, with the most lightly shorted
portfolio P1 having the lowest institutional ownership. This find-
4 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617

Table 2
Portfolio sorts by short interest.

P1 P2 P3 P4 P5 P6 P7 P8 P9 P10

Panel A: Decile portfolios sorted by SIR

Mean SIRit (%) 0.39 0.73 1.03 1.35 1.74 2.26 2.96 3.98 5.84 12.41
Mean Rating 8.47 7.94 7.93 8.10 8.42 8.81 9.29 9.82 10.53 11.86
Mispricing Score 47.32 45.92 46.05 46.69 47.30 48.35 49.55 50.75 52.57 55.01
Returns 0.89 1.01 0.99 0.93 0.97 1.00 0.85 0.98 0.87 0.62
4-factor Alpha 0.08 0.10 0.03 0.03 0.01 -0.02 -0.14 -0.06 -0.26 -0.55
Returns (NIG) 1.22 1.04 1.03 0.92 0.78 0.80 0.73 0.67 0.48 0.36
4-factor Alpha (NIG) 0.27 -0.01 -0.04 -0.24 -0.30 -0.23 -0.44 -0.51 -0.84 -0.81
Returns (IG) 0.79 0.94 1.10 0.92 0.83 1.00 1.05 0.97 0.97 0.78
4-factor Alpha (IG) -0.03 0.06 0.17 0.01 -0.14 0.09 0.07 -0.04 -0.02 -0.30
Panel B: Decile portfolios sorted by SIR
Mean Rating 10.39 9.30 8.74 8.50 8.51 8.51 8.49 8.80 9.38 10.52
Mispricing Score 51.24 48.95 48.00 47.69 47.66 47.98 47.75 48.58 49.69 51.96
Returns 1.21 0.98 0.96 0.98 0.97 0.86 0.97 0.94 0.87 0.88
4-factor Alpha 0.15 -0.01 -0.02 0.04 0.07 -0.06 0.06 -0.01 -0.09 -0.17
Returns (NIG) 1.48 1.09 1.02 0.99 0.94 0.91 0.89 0.74 0.72 0.39
4-factor Alpha (NIG) 0.35 0.07 -0.14 -0.16 -0.06 -0.17 -0.16 -0.34 -0.42 -0.78
Returns (IG) 1.17 0.90 0.96 0.97 0.91 0.91 0.95 0.93 0.89 0.96
4-factor Alpha (IG) 0.17 -0.09 0.01 0.06 0.02 0.02 0.02 0.00 -0.03 -0.04
Panel C: Firm characteristics for decile portfolios sorted by SIR
All sample
ln(Size) 14.59 15.11 15.17 15.12 14.98 14.80 14.63 14.46 14.25 13.78
B/M (%) 69.83 61.73 59.88 59.91 60.98 63.02 65.17 68.16 69.90 75.42
Leverage (%) 29.24 27.98 27.81 28.17 28.93 29.70 30.57 31.55 33.20 36.69
Dispersion (%) 8.38 7.86 8.35 8.87 8.76 9.68 9.87 9.56 9.58 7.65
ln(Volume) 10.50 11.18 11.33 11.36 11.33 11.29 11.25 11.26 11.27 11.23
IO (%) 53.58 60.48 63.27 64.14 65.23 66.31 66.48 67.22 68.35 70.29
Equity Vol. (%) 7.87 7.77 7.94 8.27 8.57 8.90 9.32 9.86 10.69 12.48
Idiosyncratic Vol. (%) 1.82 1.75 1.76 1.80 1.87 1.94 2.03 2.13 2.28 2.62
NIG subsample
ln(Size) 13.23 13.42 13.52 13.60 13.64 13.68 13.67 13.65 13.58 13.30
B/M (%) 72.77 68.87 68.69 68.15 70.12 72.84 71.51 70.73 72.41 78.89
Leverage (%) 40.38 39.60 38.88 38.13 37.47 36.77 37.49 38.51 39.07 41.51
Dispersion (%) 12.79 10.00 9.06 10.03 9.89 7.22 6.62 9.33 8.78 4.89
ln(Volume) 9.67 10.18 10.44 10.60 10.77 10.90 10.97 11.03 11.12 11.16
IO (%) 51.44 57.37 60.85 63.01 64.11 65.51 65.84 66.87 68.24 69.51
Equity Vol. (%) 10.83 11.09 11.36 11.55 11.68 12.04 12.47 12.64 13.20 14.27
Idiosyncratic Vol. (%) 2.65 2.59 2.62 2.63 2.65 2.67 2.71 2.75 2.85 2.96
IG subsample
ln(Size) 15.11 15.62 15.65 15.63 15.55 15.43 15.23 15.08 14.93 14.69
B/M (%) 68.32 59.12 58.00 58.22 58.68 60.36 62.43 63.95 66.74 71.40
Leverage (%) 25.17 25.13 25.24 25.32 25.31 26.05 26.49 27.27 27.63 28.04
Dispersion (%) 7.53 7.58 7.81 8.16 8.38 8.67 8.88 9.79 9.68 9.69
ln(Volume) 10.81 11.49 11.62 11.65 11.66 11.61 11.51 11.44 11.43 11.43
IO (%) 54.90 61.22 63.63 64.21 64.91 65.65 66.18 66.03 66.70 70.89
Equity Vol. (%) 6.75 6.94 7.11 7.30 7.47 7.62 7.80 7.97 8.25 8.97
Idiosyncratic Vol. (%) 1.55 1.55 1.57 1.58 1.60 1.63 1.66 1.69 1.74 1.84
Panel D: Firm characteristics for decile portfolios sorted by SIR
All sample
ln(Size) 14.28 14.63 14.84 14.90 14.84 14.85 14.92 14.81 14.60 14.20
B/M (%) 69.41 65.57 63.33 63.20 64.86 64.55 63.26 63.49 65.44 70.43
Leverage (%) 32.71 30.42 29.51 29.26 29.34 29.32 29.16 29.63 30.88 33.32
Dispersion (%) 9.67 9.41 8.92 8.67 8.33 8.35 8.64 8.66 8.58 9.33
ln(Volume) 11.27 11.23 11.21 11.14 10.99 11.03 11.20 11.25 11.28 11.36
IO (%) 67.75 66.78 64.58 62.10 60.28 60.32 62.74 64.95 67.29 68.53
Equity Vol. (%) 10.97 9.44 8.75 8.42 8.27 8.29 8.41 8.68 9.43 11.05
Idiosyncratic Vol. (%) 2.29 2.03 1.92 1.88 1.88 1.88 1.88 1.93 2.04 2.29
NIG subsample
ln(Size) 13.59 13.65 13.58 13.45 13.34 13.36 13.51 13.62 13.65 13.54
B/M (%) 72.63 70.82 70.99 73.16 71.98 72.50 71.40 69.09 69.00 73.33
Leverage (%) 38.25 38.00 38.41 39.06 40.07 39.59 39.00 38.03 38.23 39.16
Dispersion (%) 8.86 9.46 9.50 8.47 8.32 9.68 8.52 7.71 8.55 8.52
ln(Volume) 11.11 10.91 10.68 10.36 10.10 10.17 10.50 10.78 10.98 11.24
IO (%) 66.83 65.23 63.41 60.66 57.35 58.18 61.68 64.66 66.50 67.99
Equity Vol. (%) 13.57 12.41 11.97 11.50 11.12 11.24 11.40 11.83 12.48 13.64
Idiosyncratic Vol. (%) 2.86 2.70 2.68 2.66 2.68 2.67 2.66 2.67 2.71 2.83
IG subsample
ln(Size) 14.95 15.21 15.40 15.47 15.48 15.48 15.49 15.37 15.19 14.89
B/M (%) 66.58 62.85 60.80 60.57 61.38 61.74 60.47 61.71 63.33 67.82
Leverage (%) 27.14 26.37 25.83 25.80 25.43 25.48 25.50 25.91 26.60 27.54
Dispersion (%) 9.39 9.43 8.48 7.99 8.01 8.11 8.17 8.70 8.28 9.63
(continued on next page)
 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617 5

Table 2 (continued)

P1 P2 P3 P4 P5 P6 P7 P8 P9 P10

ln(Volume) 11.43 11.44 11.48 11.46 11.39 11.42 11.51 11.50 11.50 11.52
IO (%) 67.83 66.17 64.13 62.36 61.18 61.03 62.62 64.36 66.04 68.58
Equity Vol. (%) 8.56 7.81 7.40 7.27 7.13 7.13 7.22 7.43 7.75 8.49
Idiosyncratic Vol. (%) 1.75 1.67 1.61 1.60 1.58 1.59 1.59 1.62 1.66 1.74

Panel A presents the mean SIRit , numerical ratings, mispricing score, returns, and alphas for decile portfolios sorted by SIRit . Panel B presents the mean SIRit
and other similar variables for decile portfolios sorted by SIRit . SIRit is the change in short interest ratio for stock i from month t-1 to month t. Mispricing
score is the Stambaugh et al. (2015) mispricing measure, a higher value of which suggests more overpricing. Returns are the value-weighted portfolio returns
and alphas are estimated from the Fama-French-Carhart four-factor model, both are reported for the full sample and NIG/IG subsamples. Panels C and D present
firm characteristics for decile portfolios sorted by SIRit and SIRit , respectively, both for the full sample and for the NIG/IG subsamples. Firm characteristics
include firm size, book-to-market ratio, leverage, analyst forecast dispersion, log trading volume, institutional ownership (IO), equity return volatility, and
idiosyncratic volatility. We exclude observations with stock prices below $5 or firms with market capitalization below the NYSE’s fifth percentile, using the
breakpoints from Kenneth French’s website. The sample period is from January 1986 to February 2017.

ing is in line with Asquith et al. (2005), who view institutional
ownership as a proxy for the supply of the short-selling market.
Equity volatility and IO generally exhibit an upward trend for SIR
sorts. For SIR sorts, the distribution of IO and volatility tend to
have a milder U-shape and that of other variables exhibits a less
clear pattern.
3.2. Short interest level/change and return predictability
We next examine the relation between short interest vari-
ables and future stock returns. Excess returns are adjusted by
stock characteristics (Daniel et al., 1997) or systematic risks.
Diether (2008) documents that the majority of securities lending
contracts are closed out within two weeks. In light of the short-
lived nature of short sales, we focus on the one-month horizon
in testing cross-sectional return predictability. To obtain the return
adjusted for systematic risk (α ), we use a four-factor model that
includes the Carhart (1997) momentum factor:
rip,t +1 = αip + β1ip rM,t +1 + β2ip SMBt +1 + β3ip HMLt +1
+ β4ipUMDt +1 + eip,t +1
The dependent variable is the value-weighted return in excess
of the risk-free rate on portfolio p in rating group i and month t+1,
rM,t+1 is the market excess return, SMBt+1 is the size factor, HMLt+1
is the value factor, and UMDt+1 is the momentum factor. For ro-
bustness, we also report results using a 5-factor model that further
includes the Pástor-Stambaugh (2003, PS) liquidity factor (from
WRDS) to control for the effect of liquidity risk. In addition, we
report returns that are adjusted for the Fama and French (2015) 5-
factors and Hou et al. (2015) q-factors.2
3.2.1. Short interest level and stock return predictability
Conventional studies on the relation between short-selling ac-
tivity and future stock returns focus on the level of short interest.
We begin our analysis by examining this relation for different rat-
ing categories. Stocks are sorted into decile portfolios by short in-
terest level where P1 includes the most lightly shorted stocks and
P10 the most heavily shorted stocks. The left panel of Table 3 re-
ports the long/short portfolio test for differences in returns/alphas
for SIR sorts. Column 1 shows that the monthly return is 0.89% for
portfolio P1, and decreases to 0.62% for P10 (see also Panel A of
Table 2 for decile returns).
Column 2 shows characteristic-adjusted returns. Following
Daniel et al. (DGTW, 1997), in each month t, we construct
benchmark portfolios with three-way dependent sorting by size,
book-to-market ratio and momentum. We use all stocks in the
sample to compute the value-weighted returns for each of the
125 benchmark portfolios. We then adjust the return of each
2
The Fama and French (2015) 5-factors are downloaded from Kenneth French’s
website. We thank Kewei Hou and Lu Zhang for providing their q-factor data.
stock by the return of a benchmark portfolio that matches the
size, book-to-market ratio and past returns of that stock. Results
show that the DGTW adjusted return spread between P1 and P10
is 0.34% per month, which is significant at the 10% level. In the
next two columns, we present the results based on the alphas of
the Carhart four-factor model and the five-factor model with the
PS liquidity factor. Results continue to show a significant spread
between P1 and P10.
We then divide our sample into investment-grade (IG) and non-
investment grade (NIG) subsamples. Differences in returns/alphas
are highly significant for NIG but insignificant for IG stocks. An-
other interesting finding is that alphas are significant for the heav-
ily shorted portfolio but insignificant for the lightly shorted port-
folio for both NIG and IG groups.
Consistent with previous findings, we find that short interest
levels have predictive power for future stock returns. Importantly,
we uncover the evidence that return predictability is much higher
for speculative-grade stocks. A long-short portfolio that longs the
lightly shorted stocks (P1) and shorts the heavily shorted stocks
(P10) generates a monthly abnormal return slightly above 1% (13%
(1) per annum) for speculative-grade stocks, which is of economic sig-
nificance.
3.2.2. Short interest changes and stock return predictability
We next investigate the relationship between SIRit and future
stock returns. The right panel of Table 3 reports monthly value-
weighted average returns for the high (P1) and low (P10) portfolios
sorted by SIRit . P1 consists of stocks with the largest decrease in
the short interest ratio and P10 consists of stocks with the largest
increase in the short interest ratio. For the full sample, the return
spread is 0.33% per month and significant at the five percent level.
The return spread increases to 1.09% per month for NIG, which is
significant at the 1% level. In fact, future stock returns (t+1) exhibit
a decreasing pattern from P1 to P10 (see Panel B of Table 2) for
both full sample and NIG stocks. In contrast, the return spread is
only 0.21% per month for IG stocks and insignificant. Results show
that return predictability is driven by financial distress.
Fig. 1 plots the cumulative returns (compounded) to a long-
short portfolio that buys stocks in P1 and shorts stocks in P10
for NIG firms over the entire sample period. Each of these long-
short portfolios is constructed at the beginning of each month and
held for one month. We assume an initial investment of $1 at the
beginning of January 1986. To compare with stock market perfor-
mance, we include the cumulative return of the S&P 500 index.
The figure shows a drop in cumulative returns between 1998 and
20 0 0 for the long-short portfolio. This is because the long-short
portfolio generated significant losses for five months over this pe-
riod,3 thereby pulling down the cumulative returns of the long-
3
There are five large negative spreads (-18.35%, -9.83%, -10.01%, -12.21%, -19.28%)
between 1998 and 1999, which are primarily due to the bullish run in the stock
market during the internet bubble.
 6
Table 3
Short interest level/changes and subsequent stock returns.

Panel A: SIR (level) Panel B: SIR (change)

Raw DGTW adj. 4-factor 5-factor FF5-factor q-factor Raw DGTW adj. 4-factor 5-factor FF5-factor q-factor
return return alpha alpha alpha alpha return return alpha alpha alpha alpha

X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617

All P1 0.89 -0.33 0.08 0.10 -0.04 -0.09 1.21 -0.14 0.15 0.14 0.06 0.06
(0.79) (0.97) (-0.41) (-0.84) (1.37) (1.25) (0.53) (0.51)
P10 0.62 -0.67 -0.55∗ ∗ ∗ -0.54∗ ∗ ∗ -0.67∗ ∗ ∗ -0.68∗ ∗ ∗ 0.88 -0.37 -0.17 -0.18 -0.22∗ -0.25∗
(-4.42) (-4.33) (-5.30) (-4.85) (-1.58) (-1.64) (-1.91) (-1.94)
∗
P1 – P10 0.27 0.34 0.63∗ ∗ ∗ 0.64∗ ∗ ∗ 0.63∗ ∗ ∗ 0.59∗ ∗ ∗ 0.33 ∗∗
0.23∗ 0.32∗ ∗ 0.31∗ ∗ 0.28∗ 0.30∗ ∗
(1.28) (1.82) (3.73) (3.77) (3.65) (3.26) (2.43) (1.74) (2.30) (2.26) (1.93) (2.09)
NIG P1 1.22 -0.07 0.27 0.25 0.07 0.17 1.48 0.16 0.35 0.34 0.15 0.27
(1.46) (1.37) (0.36) (0.89) (1.43) (1.37) (0.60) (1.05)
P10 0.36 -1.06 -0.81∗ ∗ ∗ -0.80∗ ∗ ∗ -0.81∗ ∗ ∗ -0.79∗ ∗ ∗ 0.39 -1.00 -0.78∗ ∗ ∗ -0.80∗ ∗ ∗ -0.79∗ ∗ ∗ -0.77∗ ∗ ∗
(-3.69) (-3.62) (-3.57) (-3.44) (-3.51) (-2.72) (-3.40) (-3.28)
∗∗∗ ∗∗∗
P1 – P10 0.86 0.99 1.08∗ ∗ ∗ 1.05∗ ∗ ∗ 0.87∗ ∗ ∗ 0.96∗ ∗ ∗ 1.09 ∗∗∗
1.16∗ ∗ ∗ 1.14∗ ∗ ∗ 1.13∗ ∗ ∗ 0.94∗ ∗ ∗ 1.03∗ ∗ ∗
(3.01) (3.22) (3.93) (3.82) (3.13) (3.37) (3.66) (3.58) (3.70) (3.67) (3.01) (3.26)
IG P1 0.79 -0.32 -0.03 -0.02 -0.20∗ -0.23∗ ∗ 1.17 -0.19 0.17∗ 0.16 0.10 0.09
(-0.29) (-0.17) (-1.90) (-2.05) (1.66) (1.56) (0.98) (0.75)
P10 0.78 -0.41 -0.30∗ ∗ -0.28∗ ∗ -0.44∗ ∗ ∗ -0.48∗ ∗ ∗ 0.96 -0.29 -0.04 -0.03 -0.09 -0.14
(-2.49) (-2.29) (-3.54) (-3.40) (-0.35) (-0.28) (-0.75) (-1.08)
P1 – P10 0.01 0.09 0.27 0.26 0.24 0.25 0.21 0.10 0.21 0.19 0.19 0.22
(0.05) (0.50) (1.61) (1.52) (1.38) (1.39) (1.52) (0.72) (1.50) (1.38) (1.30) (1.50)

This table reports value-weighted monthly returns (Raw), characteristic-matched adjusted returns (DGTW), four (five)-factor Fama-French-Carhart (Pastor-Stambaugh) alphas, five-factor Fama-French (2015) alphas,
and Hou, Xue and Zhang (2015) q-factor alphas in month t+1 for decile portfolios formed by sorting SIRit (SIRit ) and rating. SIRit is the short interest level for stock i in month t. SIRit is the change in short
interest ratio for stock i from month t-1 to month t. P1 and P10 include portfolios of stocks sorted by ()SIRit in the 1st and 10th deciles. We exclude observations with stock prices below $5 or firms with
market capitalization below the NYSE’s fifth percentile, using the breakpoints from Kenneth French’s website. The DGTW-adjusted returns are stock returns adjusted for the returns of the benchmark portfolio
formed by the size, book-to-market and momentum factors to which the stock belongs. To estimate the portfolio alpha, we use the following factor model in our baseline study:
rip,t+1 = αip + β1ip rM,t+1 + β2ip SMBt+1 + β3ip HMLt+1 + β4ipUMDt+1 + eip,t+1
where rip,t+1 is the value-weighted return in excess of the risk-free rate on portfolio p in rating group i and month t+1, rM,t+1 is the market excess return, SMBt+1 is the size factor, HMLt+1 is the value factor,
and UMDt+1 is the momentum factor. In extended studies, we report alphas for the 5-factor model with the Pástor-Stambaugh liquidity factor LIQt+1 , the Fama-French 5-factor model with the profitability factor
RMWt+1 and the investment factor CMAt+1 , and the Hou-Xue-Zhang (2015) q-factor model. The sample period runs from January 1986 to February 2017. The t-values are in parentheses and the signs ∗ ∗ ∗ , ∗ ∗ and
∗
indicate significance at the 1%, 5% and 10% levels, respectively.
 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617 7

Portfolio cumulative returns

40 30
Cumulative Return
10 20 0

1986 1991 1996 2001 2006 2011 2016

t

long-short portfolio cumulative returns

cumulative returns of S&P 500 index

Fig. 1. This graph plots the cumulative returns on a long-short portfolio that buys stocks in P1 and shorts stocks in P10 for the NIG group.

short portfolio. Despite this setback, the figure shows that the ini-
tial investment increases to more than $30 at the end of the sam-
ple period (February 2017), which is more than three times the
S&P 500 return.
Column 2 in the right panel of Table 3 reports the results of
DGTW characteristic-adjusted returns. After adjusting for the char-
acteristics of size, book-to-market ratio and momentum, return
spreads continue to be significant for the whole sample (0.23%)
and NIG (1.16%) and insignificant for IG. These results show that
the predictive power of short interest changes for returns is robust
to controlling for the effects of size, book-to-market and momen-
tum returns.
Column 3 reports alphas from the four-factor model. The high-
low risk-adjusted portfolio returns (P1 – P10) are significant at
the five percent level for the full sample. When dividing the sam-
ple into NIG and IG groups, we again find that results are signif-
icant only for the firms with a speculative-grade rating. A long-
short portfolio that longs the stocks with the most negative change
in the short interest ratio (P1) and shorts the stocks with the
most positive change (P10) delivers a monthly abnormal return of
1.14% or an annualized return of about 15% for NIG stocks. This is
a highly statistically significant and economically meaningful fig-
ure, which is larger than the result sorted by the level of short
interest.
The most negative monthly return is -78 basis points in P10 of
NIG, while the most positive monthly return is from P1 with 35
basis points. Financial distress provides a link between changes in
short interest and return predictability, as stocks with a large in-
crease (decrease) in short interest experience a significant subse-
quent decrease (increase) in stock prices.
Our results show that the payoff derives more from the short
leg than the long leg, regardless of whether we sort portfolios by
SIRit or SIRit . This finding differs from the results reported by
Boehmer et al. (2010) but is in line with Diether et al. (2009). One
possible cause for the discrepancy between our findings and those
of Boehmer et al. (2010) is that we exclude stocks with prices be-
low $5 and firms with value below the fifth percentile of NYSE
market capitalization, while Boehmer et al. (2010) do not. Thus,
the findings of Boehmer et al. (2010) could be driven by small
stocks. Excluding stock prices below $5, Diether et al. (2009) find
that the short leg dominates short-term trading returns similar to
ours.
To further control for liquidity risk, we run regressions for a
5-factor model with the Pástor-Stambaugh liquidity factor. The re-
sults in the next column in the right panel of Table 3 show a simi-
lar pattern after controlling for liquidity risk effects. For NIG firms,
the monthly alpha spread is 1.13% and significant at the one per-
cent level. Results again show that short interest changes predict
the future returns of stocks in the cross-section, and that this re-
turn predictability concentrates in distressed stocks. The last two
columns report the alphas from the Fama and French (2015) 5-
factors model and Hou et al. (2015) q-factors model, and the re-
sults are robust.
In summary, we find that return predictability associated with
short interest is concentrated in speculative-grade stocks, regard-
less of whether we use the level or change of short interest as
a predictor for future returns. More importantly, the results are
stronger when we use short interest changes as a predictor, con-
sistent with the argument of Rapach et al. (2016) that changes in
short interest are a better measure of changes in investors’ beliefs
than short interest levels. Hence, we focus on the results based on
the signal of SIR in the remaining analysis.
3.3. Controlling for cross-sectional effects
To examine the robustness of our results, we control for a bat-
tery of cross-sectional effects using bivariate portfolio sorts. The
ability of short interest changes to predict future stock returns
could be linked to firm characteristics. For example, it is easier
to borrow stocks from large firms as more stocks are available
for lending, and liquid stocks are easier to short (Gervais et al.,
2001). Similarly, when institutional ownership is low, fewer stocks
8 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617
are available for lending (Asquith et al., 2005; Nagel, 2005) and
the effect of short interest could be due to short-selling fea-
sibility. Short interest can also be linked to divergences of in-
vestor opinion (Boehme et al., 2006), and expected returns are
positively related to leverage and the book-to-market ratio. These
raise a concern that return predictability may simply reflect these
characteristics.
To address this concern, we perform portfolio analysis by con-
trolling for all of the above firm/stock characteristics. The re-
sults (see the online appendix) show that the return predictabil-
ity associated with short interest changes is robust to all controls.
While there are variations in return predictability across charac-
teristics, changes in short interest appear to have an indepen-
dent predictive power for future returns over and beyond any firm
characteristic.
3.4. Cross-sectional regressions
We further assess the robustness of return predictability by
SIR using cross-sectional regressions, which have the advantage
of controlling for the effects of multiple firm characteristic vari-
ables simultaneously. We run the Fama-MacBeth (1973) regression
of future returns on SIR and other control variables each month
and average the parameter estimates over time to infer the signif-
icance of these parameters.
Table 4 reports the results of Fama-MacBeth regressions with
different specifications. In column 1, we run the regression using
the full sample and control for the effects of important variables in
the literature, such as size, book-to-market ratio, lagged six-month
returns (momentum), leverage and volume. The coefficient of SIR
is -6.95 and significant at the 5% level, suggesting that future stock
returns decrease with SIR, a finding consistent with our portfolio
analysis. Consistent with the literature, small stocks, value stocks
and stocks with high volume have higher returns (see Fama and
French, 1992; Gervais et al., 2001). In column 2, we incorporate
lagged institutional ownership, changes in institutional ownership,
the Stambaugh et al. (2015) mispricing measure and its interaction
with a dummy variable, where DSIRt(90) takes a value of one for
stocks in the highest decile of short interest changes. We find that
changes in institutional ownership (IOt ) have a significant posi-
tive effect on stock returns. Moreover, stocks with high mispricing
scores have lower returns. Controlling for all variables, the coeffi-
cient on SIR remains significantly negative.
We next run regressions for NIG and IG separately. When in-
cluding all control variables, the SIR coefficient is much larger for
NIG stocks and significant at the 5% level. In contrast, SIR has
weak power in predicting cross-sectional returns for IG stocks. Al-
though the coefficient of SIR is still negative for these stocks, it is
statistically insignificant.
In Panel B of Table 4, we report our results using the level of
short interest as an explanatory variable. The results are broadly
consistent with the argument that the predictive power of short
interest is driven by NIG firms, though they are not as strong as in
Panel A.
Collectively, the preceding analyses show that the predictive
power of short interest changes for future returns is concentrated
in the worst-rated stocks. The predictability of stock returns with
short interest disappears when the firms rated BB+ or below are
excluded from the sample. This finding is robust to controlling for
a wide spectrum of cross-sectional effects.
4. Robustness tests
In this section, we perform additional tests for robustness. We
first examine the predictive power of short interest changes for
different subperiods and the subsample that includes only NYSE
stocks to see if short-interest return predictability is sample- or
time-dependent. We also conduct tests based on finer rating cate-
gories to reveal more detailed rating effects and use the expected
default frequency from the structural approach of KMV-Merton as
an alternate proxy for firms’ financial distress risk. Lastly, we em-
ploy the mispricing score proposed by Stambaugh et al. (2015) to
further understand the role of short selling.
4.1. Subperiod analysis
One potential concern is that abnormal returns may be de-
pendent on the sample period. To address this concern, we per-
form subperiod analysis by dividing the whole sample period into
two subperiods: January 1986 ̶ December 20 0 0 and January 2001
̶ February 2017. We then regress value-weighted portfolio returns
on risk factors to obtain risk-adjusted returns for each subperiod,
using the four-factor model. The left panel of Table 5 presents the
abnormal returns for both subperiods. Again, we find that changes
in short interest have a predictive power primarily for speculative-
grade stocks. In both subperiods, the differences in abnormal re-
turns between P1 and P10 are only statistically significant for firms
with a speculative grade. A long-short portfolio that longs P1 and
shorts P10 delivers almost the same monthly abnormal return (al-
pha) in both periods for NIG stocks, suggesting that results are not
dependent on the sample period.
The literature has documented that investor sentiment af-
fects return predictability. Baker and Wurgler (20 06, 20 07) find
that there is a negative relationship between investor sentiment
and the cross-section of returns for stocks whose value is more
subjective and harder to arbitrage. To explore the role of in-
vestor sentiment in return predictability by short interest, we
divide the sample period into two subperiods based on the
Baker-Wurgler sentiment index, using the same procedure as in
Stambaugh et al. (2012). The second panel of Table 5 reports the
results. The risk-adjusted return (alpha) spread is 0.67% in the low
sentiment subperiod and 1.52% in the high sentiment subperiod for
NIG stocks. Consistent with Stambaugh et al. (2012), the short sale
anomaly is more pronounced when investor sentiment is high.
The literature has also suggested that return predictability de-
pends on macroeconomic conditions (Rapach et al., 2010). To see
whether the predictive power of short interest depends on the
economy, we again divide the whole sample period into two sub-
periods, this time using the real GDP growth rate provided by
the Federal Reserve Bank in St. Louis, to explore the relationship
of cross-sectional return predictability by SIR to macroeconomic
conditions. The third panel of Table 5 shows that the alpha spread
for speculative-grade firms is 1.46% in a bad economy and 1.04%
in a good economy, suggesting that returns are more predictable
in a bad economy. This result is consistent with the finding of
Rapach et al. (2010) that stock returns are more predictable in a
bad economy.
Finally, the predictive power of short interest may depend on
stock market liquidity. To examine this possibility, we calculate re-
turn spreads conditioned on the high/low illiquidity index, con-
structed from daily CRSP data using the Amihud (2002) method.4
The right panel of Table 5 reports the results. The alpha spread
for speculative-grade firms is 1.51% in low liquidity periods (high
Amihud illiquidity) and 0.77% in high liquidity periods. Thus, the
predictive power of short interest changes is stronger when mar-
ket liquidity is low.
4
The Amihud illiquidity measure is the cross-sectional average of daily absolute
returns over dollar volume each month. To be included, the stock price must be ≥
$5 and have trades for more than 15 days in a given month.
 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617 9

Table 4
Cross-sectional regressions of future excess returns on short interest.

Variables Full sample Full sample Full sample NIG NIG NIG IG IG IG

Panel A: Changes in short interest ratio as the predictor

SIRt -6.95∗ ∗ -7.22∗ ∗ -8.88∗ ∗ -13.22∗ ∗ -13.47∗ ∗ -14.58∗ ∗ -3.06 -5.64∗ -3.48
(-2.23) (-2.19) (-2.57) (-2.35) (-2.28) (-2.46) (-0.94) (-1.70) (-0.95)
Ln(size) -0.42∗ ∗ ∗ -0.38∗ ∗ ∗ -0.34∗ ∗ ∗ -1.08∗ ∗ ∗ -0.84∗ ∗ ∗ -0.84∗ ∗ ∗ -0.17∗ ∗ -0.18∗ ∗ ∗ -0.17∗ ∗
(-5.76) (-5.20) (-4.52) (-10.60) (-7.93) (-8.17) (-2.47) (-2.83) (-2.38)
B/M 0.52∗ ∗ ∗ 0.70∗ ∗ ∗ 0.59∗ ∗ ∗ 0.79∗ ∗ ∗ 0.81∗ ∗ ∗ 0.79∗ ∗ ∗ 0.32∗ ∗ ∗ 0.53∗ ∗ ∗ 0.37∗ ∗ ∗
(6.54) (7.08) (6.77) (6.20) (5.77) (5.82) (3.50) (4.65) (3.80)
r[-6,-1] -0.12 -0.44 -0.26 0.45 -0.15 0.24 -0.64∗ -0.83∗ ∗ -0.65∗
(-0.39) (-1.31) (-0.80) (1.47) (-0.45) (0.73) (-1.68) (-2.17) (-1.68)
Leverage -0.16 0.10 -0.29 0.13 0.45 -0.04 -0.46∗ ∗ -0.16 -0.51∗ ∗
(-0.87) (0.49) (-1.46) (0.38) (1.19) (-0.10) (-2.05) (-0.69) (-2.23)
Volume 0.30∗ ∗ ∗ 0.29∗ ∗ ∗ 0.24∗ ∗ ∗ 0.56∗ ∗ ∗ 0.48∗ ∗ ∗ 0.43∗ ∗ ∗ 0.15∗ ∗ 0.16∗ ∗ ∗ 0.15∗ ∗
(4.70) (4.67) (3.78) (7.64) (5.91) (5.90) (2.44) (2.92) (2.40)
IOt-1 -0.41∗ -0.91∗ ∗ ∗ 0.02
(-1.77) (-2.88) (0.09)
IOt 10.55∗ ∗ ∗ 15.68∗ ∗ ∗ 9.24∗ ∗ ∗
(6.23) (4.58) (6.05)
Mispricing Score -0.02∗ ∗ ∗ -0.02∗ ∗ ∗ -0.02∗ ∗ ∗
(-6.17) (-4.35) (-5.12)
Mispricing Score x -0.00 -0.02 -0.01
DSIRt(90) (-0.73) (-1.20) (-1.35)
PMt+1 0.08∗ ∗ ∗ 0.13∗ ∗ ∗ 0.05∗ ∗
(3.71) (2.79) (2.08)
PMt+1 x DSIRt(10) 0.12 0.40∗ 0.01
(1.43) (1.66) (0.05)
Constant 3.68∗ ∗ ∗ 2.92∗ ∗ ∗ 3.06∗ ∗ ∗ 9.55∗ ∗ ∗ 7.40∗ ∗ ∗ 7.67∗ ∗ ∗ 1.76∗ ∗ ∗ 1.60∗ ∗ 1.71∗ ∗
(5.46) (4.09) (4.31) (9.35) (6.85) (7.14) (2.74) (2.41) (2.53)
Observations 285,081 264,989 253,755 98,251 86,577 88,637 186,830 178,412 165,118
Avg R-squared 0.06 0.08 0.07 0.07 0.11 0.09 0.07 0.10 0.08

Full sample Full sample NIG NIG IG IG

Panel B: Short interest level as the predictor

SIRt -2.46∗ -2.55∗ -3.69∗ ∗ -3.62∗ ∗ -2.01 -2.06
(-1.93) (-1.83) (-2.52) (-2.27) (-1.30) (-1.00)
Ln(size) -0.21∗ ∗ ∗ -0.17∗ ∗ ∗ -0.54∗ ∗ ∗ -0.38∗ ∗ ∗ -0.04 -0.06∗
(-5.75) (-4.41) (-7.84) (-5.31) (-1.37) (-1.74)
B/M 0.54∗ ∗ ∗ 0.65∗ ∗ ∗ 0.89∗ ∗ ∗ 0.81∗ ∗ ∗ 0.30∗ ∗ ∗ 0.44∗ ∗ ∗
(6.84) (6.84) (6.83) (5.76) (3.37) (4.27)
r[-6,-1] -0.03 -0.33 0.49 -0.09 -0.48 -0.66∗
(-0.08) (-1.05) (1.57) (-0.26) (-1.38) (-1.90)
Leverage -0.02 0.18 0.30 0.52 -0.43∗ ∗ -0.14
(-0.12) (0.95) (0.92) (1.39) (-1.99) (-0.67)
Volume 0.35∗ ∗ ∗ 0.32∗ ∗ ∗ 0.69∗ ∗ ∗ 0.58∗ ∗ ∗ 0.15∗ ∗ ∗ 0.17∗ ∗ ∗
(6.07) (5.65) (8.97) (6.83) (2.86) (3.46)
IOt-1 -0.22 -0.74∗ ∗ 0.22
(-0.97) (-2.29) (0.92)
IOt 10.04∗ ∗ ∗ 15.10∗ ∗ ∗ 9.20∗ ∗ ∗
(6.13) (4.32) (6.35)
Mispricing Score -0.02∗ ∗ ∗ -0.02∗ ∗ ∗ -0.01∗ ∗ ∗
(-5.16) (-3.88) (-4.93)
Mispricing Score x -0.01 -0.00 -0.00
DSIRt(90) (-1.55) (-0.20) (-0.09)
∗∗∗
Constant 4.46 3.81∗ ∗ ∗ 9.22∗ ∗ ∗ 6.97∗ ∗ ∗ 1.86∗ ∗ ∗ 2.06∗ ∗ ∗
(7.12) (5.74) (9.91) (7.02) (3.58) (3.70)
Observations 285,081 264,989 98,251 86,577 186,830 178,412
Avg R-squared 0.06 0.08 0.07 0.11 0.07 0.10

This table reports the results of the Fama-MacBeth regressions. For each month t, we run cross-sectional regressions of stock excess returns for
the next month (%) on the change in short interest ratio and control variables:

ri,t+1 = αt + βt SIRit + Xt γt + et
where ri , t+1 is stock i’s excess return in month t+1 and SIRit is the change in short interest ratio for stock i from month t-1 to month t. X is
a vector of control variables including size, book to market ratio, past six-month returns, leverage, institutional ownership (lagged institutional
ownership and changes in institutional ownership), volume, analyst forecast dispersion, changes in future profit margin (in %) and the mispricing
score of Stambaugh et al. (2015). In Panel B, the predictor is replaced with the level of short interest SIRit . The t-values are in parentheses and
the signs ∗ ∗ ∗ , ∗ ∗ and ∗ indicate significance at the 1%, 5% and 10% levels, respectively.

4.2. Using only NYSE stocks
To see if our results are sensitive to sample selection, we next
reconstruct a sample that includes only stocks listed in the NYSE.
We form the portfolios using the same procedure as in the base-
line analysis, and regress value-weighted returns on risk factors to
obtain alphas using the four-factor model. Panel A of Table 6 shows
that the long-short portfolio returns are significant at the 1% level
for NIG firms and at the 5% level for the full sample. These find-
ings are in line with the results based on the broad sample in
Table 3 and show the robustness of our results to the exclusion
of AMEX and NASDAQ stocks.
10 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617

Table 5
Subperiod Analysis.

P1 P10 P1 – P10 P1 P10 P1 – P10 P1 P10 P1 – P10 P1 P10 P1-P10

Jan 1986 – Dec 20 0 0 Low sentiment (BW) Low GDP growth rate Low Amihud Illiquidity

All 0.13 -0.24 0.37∗ 0.01 -0.13 0.14 0.21 -0.16 0.37∗ 0.04 -0.07 0.12
(0.79) (-1.43) (1.76) (0.04) (-0.91) (0.68) (1.31) (-0.97) (1.72) (0.32) (-0.50) (0.65)
NIG 0.41 -0.70∗ 1.11∗ ∗ 0.04 -0.63∗ ∗ 0.67∗ 0.32 -1.13∗ ∗ ∗ 1.46∗ ∗ ∗ 0.10 -0.66∗ ∗ 0.77∗ ∗
(0.97) (-1.94) (2.10) (0.13) (-2.37) (1.67) (1.03) (-3.56) (3.42) (0.39) (-2.51) (2.25)
IG 0.07 -0.14 0.21 -0.04 0.08 -0.11 0.17 -0.09 0.26 0.18 0.15 0.03
(0.45) (-0.89) (0.96) (-0.24) (0.48) (-0.57) (1.07) (-0.55) (1.20) (1.25) (0.90) (0.16)
Jan 2001 – February 2017 High sentiment (BW) High GDP growth rate High Amihud Illiquidity

All 0.12 -0.22 0.34∗ 0.21 -0.24 0.45∗ ∗ 0.13 -0.21 0.34∗ 0.15 -0.27∗ 0.42∗ ∗
(0.86) (-1.50) (1.74) (1.33) (-1.35) (2.19) (0.89) (-1.38) (1.77) (0.91) (-1.76) (2.13)
NIG 0.27 -0.85∗ ∗ ∗ 1.12∗ ∗ ∗ 0.47 -1.05∗ ∗ ∗ 1.52∗ ∗ ∗ 0.30 -0.74∗ ∗ ∗ 1.04∗ ∗ 0.55 -0.96∗ ∗ ∗ 1.51∗ ∗ ∗
(1.18) (-3.32) (3.59) (1.19) (-2.97) (3.15) (0.78) (-2.74) (2.45) (1.36) (-3.06) (3.15)
IG 0.19 0.01 0.18 0.19 -0.09 0.29 0.13 -0.13 0.26 -0.01 -0.04 0.03
(1.31) (0.05) (0.92) (1.24) (-0.55) (1.32) (0.95) (-0.87) (1.39) (-0.09) (-0.27) (0.15)

This table reports the four-factor Fama-French-Carhart alphas for decile portfolios sorted by SIRit and rating for different subperiods. SIRit is
the change in short interest ratio for stock i from month t-1 to month t. We exclude observations with stock prices below $5 or firms with market
capitalization below the NYSE’s fifth percentile breakpoint, using the breakpoints from Kenneth French’s website. We report alphas estimated by
the following factor model:
rip,t+1 = αip + β1ip rM,t+1 + β2ip SMBt+1 + β3ip HMLt+1 + β4ipUMDt+1 + eip,t+1
where rip,t+1 is the value-weighted return in excess of the risk-free rate on portfolio p in rating group i and month t+1, rM,t+1 is the market
excess return, SMBt+1 is the size factor, HMLt+1 is the value factor and UMDt+1 is the momentum factor. The last column in each panel reports the
difference between P1 and P10. The sample period runs from January 1986 to February 2017. The t-values are in parentheses and the signs ∗ ∗ ∗ , ∗ ∗
and ∗ indicate significance at the 1%, 5% and 10% levels, respectively.

Table 6 portfolio risk-adjusted returns are significant at the 1% level for

Results based on NYSE stocks and finer S&P ratings.
rating groups BB and B. For the lowest investment-grade category,
Rating # of obs. P1 P10 P1 – P10 BBB, the risk-adjusted return spread is barely significant at the 10%
Panel A: NYSE stocks only level, and presents a much smaller magnitude. Finally, for ratings
All 260,963 0.12 -0.22∗ 0.33∗ ∗ above BBB, return spreads are all insignificant. Results again show
(1.06) (-1.94) (2.32) that the short interest anomaly concentrates in low-grade stocks.
NIG 83,729 0.12 -0.79∗ ∗ ∗ 0.91∗ ∗ ∗
(0.48) (-3.25) (2.78)
IG 177,234 0.12 -0.07 0.18
4.4. Using expected default frequency (EDF) as a measure of distress
(1.08) (-0.58) (1.27) risk
Panel B: Finer S&P ratings
AA 18,608 0.11 -0.16 0.27 Following the convention in financial distress studies, we have
(0.54) (-0.73) (0.93)
used credit ratings to identify distressed firms. To see if our re-
A 71,612 0.15 -0.07 0.22
(1.10) (-0.49) (1.11) sults are robust to different credit risk metrics, we next use the
BBB 97,418 0.21 -0.11 0.32∗ expected default frequency (EDF) as an alternative measure of dis-
(1.50) (-0.76) (1.74) tress risk. We calculate the distance to default and EDF using the
BB 71,960 0.44∗ -0.60∗ ∗ 1.04∗ ∗ ∗ KMV-Merton model and use the EDF measure to perform portfolio
(1.67) (-2.17) (3.08)
analysis.5 For each month t, we first sort stocks into quintiles by
B 35,588 0.69∗ -0.84∗ ∗ 1.53∗ ∗ ∗
(1.76) (-2.17) (2.90) EDFit . Then, for each quintile, we further sort stocks into deciles by
SIRit . Finally, we calculate value-weighted returns for each port-
This table reports the four-factor Fama-French-Carhart alphas for the decile
portfolios sorted by SIRit for NYSE stocks (Panel A) and for S&P rating cat-
folio in month t+1.
egories (Panel B). SIRit is the change in short interest ratio for stock i from Table 7 reports the value-weighted monthly returns and the al-
month t-1 to month t. We report alphas estimated by the following factor phas for P1 and P10 portfolios for each EDF quintile. Alphas are es-
model: timated using the Fama-French-Carhart four-factor model. The re-
rip,t+1 = αip + β1ip rM,t+1 + β2ip SMBt+1 + β3ip HMLt+1 + β4ipUMDt+1 + eip,t+1
sults again show that the predictability of returns by short interest
where rip,t+1 is the value-weighted return in excess of the risk-free rate on port-
folio p in rating group i and month t+1, rM,t+1 is the market excess return, is concentrated in firms with high default risk. The alpha spread
SMBt+1 is the size factor, HMLt+1 is the value factor and UMDt+1 is the momen- increases as default probability increases. The largest alpha spread
tum factor. The sample period runs from January 1986 to February 2017. The (1.18%) occurs in the highest EDF quintile, which is highly signifi-
t-values are in parentheses and the signs ∗ ∗ ∗ , ∗ ∗ and ∗ indicate significance at cant (t = 3.79). Alpha spreads are also significant for EDF quintiles
the 1%, 5% and 10% levels, respectively.
3 and 4, but they are much smaller than that for quintile 5. The
short interest anomaly is clearly most pronounced for distressed
firms. Thus, our findings are robust to different measures of finan-
4.3. Results by rating category cial distress.

To determine which segment of firms drives return predictabil-
ity, we divide our data into more detailed credit rating subsam-
ples. Since the number of available observations is much smaller
for stocks with an AAA rating or ratings below B, we focus on
the data for stocks with ratings in the AA to B range. For each
S&P rating group in month t, we sort stocks into deciles based on
SIRit . Panel B of Table 6 presents the abnormal returns for in-
dividual rating categories. The spreads between the high and low
4.5. Stock overpricing
Diether et al. (2009) document that short sellers trade against
short-term stock overpricing. Rapach et al. (2016) show that
5
This structural model is used to obtain distance to default (DD). The expected
default frequency (EDF) equals N(-DD), where N() is the cumulative normal distri-
bution function. The higher the EDF, the higher the default probability.
 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617 11

Table 7 for distressed firms. The left side of Panel A in Table 8 reports the
Results based on expected default frequency (EDF).
contemporaneous mean of the SIR for high and low return portfo-
EDF quintiles Raw return Four-factor alpha lios. The difference in short interest levels between high and low
P1 P10 P1 – P10 P1 P10 P1 – P10
return portfolios is insignificant. Results show that the overpricing
of stocks is more apparent when we measure short-selling pres-
Low 0.99 1.13 -0.15 0.20 0.05 0.15
sure by changes in short interest.
(-0.56) (1.39) (0.31) (0.64)
2 1.09 1.09 -0.00 0.29∗ 0.06 0.23 Short sellers tend to increase their trading activity following
(-0.02) (1.85) (0.36) (1.02) positive stock returns. However, stocks with positive returns are
3 1.11 0.76 0.34 0.23 -0.33 0.56∗ ∗ not necessarily overvalued. It is possible that these stocks may
(1.22) (1.21) (-1.64) (2.07) have been undervalued and their prices are adjusting back to
4 1.20 0.74 0.47 0.31 -0.39∗ 0.70∗ ∗
(1.60) (1.62) (-1.87) (2.40)
their fair values. To address this issue, we construct the mis-
High 1.14 0.12 1.03∗ ∗ ∗ 0.17 -1.01∗ ∗ ∗ 1.18∗ ∗ ∗ pricing score suggested by Stambaugh et al. (2015) to directly
(3.04) (0.72) (-4.42) (3.79) measure each stock’s propensity to be overvalued or underval-
This table reports the value-weighted monthly returns (Raw) and the four-factor
ued. The mispricing score is a percentile number averaged across
Fama-French-Carhart alphas for stock portfolios. Each month we sort stocks on ex- the ranking percentiles for each of the 11 anomalies studied by
pected default frequency (EDF) into quintiles, and then for each EDF quintile we Stambaugh et al. (2015). The higher the score, the greater the de-
further sort stocks on SIRit into deciles. EDF is computed using the KMV Model. gree of overpricing.
SIRit is the change in short interest ratio for stock i from month t-1 to month
We then sort our sample into deciles by mispricing score (MS)
t. We estimate alphas in month t+1 for each decile portfolio formed by SIR in
month t using the following four-factor model: where MS1 consists of the most underpriced stocks and MS10 is
rip,t+1 = αip + β1ip rM,t+1 + β2ip SMBt+1 + β3ip HMLt+1 + β4ipUMDt+1 + eip,t+1 the portfolio with the most overpriced stocks. The average score
where rip,t+1 is the value-weighted return on portfolio p in excess of the risk-free for MS1 (MS10) is 28.97 (71.81). Panel B of Table 8 reports the av-
rate in rating group i and month t+1, rM,t+1 is the market excess return, SMBt+1 erage short interest level as well as changes in short interest for
is the size factor, HMLt+1 is the value factor and UMDt+1 is the momentum factor.
The sample period runs from January 1986 to February 2017. The t-values are in
these mispriced portfolios. The difference in short interest levels
parentheses and the signs ∗ ∗ ∗ , ∗ ∗ and ∗ indicate significance at the 1%, 5% and 10% between MS1 and MS10 portfolios is 2.78% for the full sample,
levels, respectively. which is significant at the 1% level. The right side reports the dis-
tribution of SIR. The difference in SIRs between MS1 and MS10
is 5 basis points, which is significant at the 1% level. The SIR of
changes in short interest are a more reliable measure for varia- the MS1 portfolio is negative, suggesting that short selling attenu-
tions in short-sellers’ beliefs, which better explains short-sellers’ ates for underpriced stocks. In the next two rows, we find a simi-
behavior. As an increase in short interest reflects pressure to short lar pattern for NIG and IG groups. NIG firms have higher mispricing
a stock, we should observe a greater tendency to short sell a stock scores (see the rightmost two columns), and spreads (Diff) of short
when it demonstrates a large price increase. interest level and changes are much higher for these firms. These
To examine this possibility, we sort stocks into deciles by con- results suggest that more overpriced stocks are associated with a
temporaneous returns. The right side of Panel A in Table 8 reports larger level and change in short interest, and that this relation is
the contemporaneous mean of the SIR for high and low return more pronounced for distressed firms.
portfolios. The results for the full sample show that stocks with
high current returns are associated with a large increase in short
interest. The difference in short interest changes between the high 5. Changes in short interest and firms’ future profitability
and low stock return portfolios is 0.10, which is significant at the
1% level. When dividing the whole sample into NIG and IG groups, While the results above show that the short interest anomaly
we find the difference in SIR between high and low return port- is primarily driven by credit risk, the question of which economic
folios is significant for both rating groups. More importantly, the factors drive the predictive power of short interest remains unan-
speculative-grade stocks have a much larger spread of short inter- swered. In this section, we examine the possible sources of the
est changes (0.14). Thus, while short interest generally rises when predictive power of short interest changes for stock returns of dis-
stock return increases, this positive relationship is much stronger tressed firms.

Table 8
Short interest and stock mispricing.

SIRt (%) SIRt (%) Mispricing Score

Panel A: SIR/SIR of portfolios sorted by contemporaneous returns

Low High Diff t Low High Diff t

All sample 4.38 4.30 -0.08 -0.42 -0.01 0.09 0.10∗ ∗ ∗ 5.23
NIG 5.77 5.48 -0.29 -1.35 -0.00 0.14 0.14∗ ∗ ∗ 4.40
IG 2.71 2.73 0.02 0.16 -0.02 0.07 0.09∗ ∗ ∗ 5.83

Panel B: SIR/SIR of portfolios sorted by the mispricing score of Stambaugh et al. (2015)
MS1 MS10 Diff t MS1 MS10 Diff t MS1 MS10
∗∗∗ ∗∗∗
All sample 2.35 5.13 2.78 17.07 -0.01 0.04 0.05 2.83 28.97 71.81
NIG 4.49 6.62 2.13∗ ∗ ∗ 10.27 -0.01 0.08 0.09∗ ∗ ∗ 3.12 33.86 76.17
IG 1.97 2.91 0.94∗ ∗ ∗ 8.58 -0.01 0.03 0.04∗ ∗ ∗ 2.65 27.90 67.65

Panel A presents the mean SIRit and SIRit for decile portfolios sorted by contemporaneous stock returns. Panel B
presents the mean SIRit and SIRit for decile portfolios sorted by the mispricing score of Stambaugh et al. (2015).
SIRit is the change in short interest ratio for stock i from month t-1 to month t. We exclude observations with
stock prices below $5 or firms with market capitalization below the NYSE’s fifth percentile, using the breakpoints
from Kenneth French’s website. The last column reports the difference between Low and High (Diff). The sample
period runs from January 1986 to February 2017. The signs ∗ ∗ ∗ and ∗ ∗ indicate significance at the 1% and 5% levels,
respectively.
12 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617

Table 9 formed traders to trade the worst-rated stocks to maximize the

Cross-sectional regressions of excess returns on profit margin.
benefit of their private information for firm profitability. To in-
Variables Full sample NIG IG Full sample vestigate this possibility, we examine the sensitivity of stock re-
PM 13.86∗ ∗ ∗ 18.89∗ ∗ ∗ 10.32∗ ∗ ∗ 9.99∗ ∗ ∗ turns to firm performance. We use profit margin (PM) as a mea-
(12.87) (10.71) (10.04) (9.88) sure of firms’ performance, which is the net income (NIQ) over
PM x DNIG 9.36∗ ∗ ∗ sales (SALEQ) adjusted for the industry norm. We use the first two
(5.41) digits of the NAICS (North American Industry Classification Sys-
Ln(size) -0.03 -0.06 -0.05 -0.03
tem) to identify the industry that the firm belongs to, and subtract
(-0.85) (-0.93) (-1.38) (-0.84)
B/M 0.45∗ ∗ ∗ 0.53∗ ∗ ∗ 0.38∗ ∗ ∗ 0.44∗ ∗ ∗ the industry median from each firm’s profit margin to obtain the
(5.50) (4.51) (4.03) (5.37) industry-adjusted PM.
r[-6,-1] 0.03 0.73∗ ∗ -0.78∗ 0.01 To estimate the sensitivity of stock returns to changes in firm
(0.08) (2.12) (-1.87) (0.03)
performance, we regress stock excess returns against the profit
Constant 1.10 1.41 1.40∗ ∗ 1.12
(1.48) (1.42) (2.40) (1.50) margin (PM) with control variables. We run the regressions using
265,279 95,611 169,668 265,279 the full sample, as well as the subsamples of IG and NIG stocks.
Observations Table 9 shows that sensitivity of returns to changes in firms’ prof-
Avg 0.05 0.06 0.06 0.06 itability is much higher for NIG stocks than for IG stocks. Using a
R-squared
dummy interaction variable (PM x DNIG ) for NIG in the regression,
For each month t, we run cross-sectional regressions of stock excess
we find that the higher sensitivity of NIG stocks is statistically sig-
returns (%) on profit margin and other controls:

rit = αt + βt P Mit + Xt−1 γt−1 + et nificant and economically meaningful.
where rit is stock i’s excess return in month t and PMit is stock i’s profit One issue of particular interest is whether changes in short
margin in month t, or the net income (NIQ) over sales (SALEQ). For each interest predict firms’ future profitability. To address this issue,
quarterly accounting ratio ending in quarter q, all three months in that we run cross-sectional regressions of future profit margin (PM)
quarter are assigned with the corresponding ratio. X is a vector of con-
trol variables including size, book to market ratio and past six-month
on current SIR. Table 10 shows that SIR has significant predic-
returns. We report the time-series average of these cross-sectional re- tive power for the future profitability of distressed firms. A higher
gression coefficients with their associated sample t-statistics (in paren- (lower) value of short interest changes, SIR, is associated with a
theses). The sample period runs from January 1986 to February 2017. lower (higher) future profit for NIG firms. Conversely, there is no
The signs ∗ ∗ ∗ , ∗ ∗ , and ∗ indicate significance at the 1%, 5% and 10% lev-
significant relationship between short interest changes and the fu-
els, respectively.
ture profitability of IG firms.
A potential concern is that uncertainty for the firm may drive
the return predictability of its stock. To check this possibility,
Active short sellers generally trade more following a stock price
we first compute equity volatility as the standard deviation of
increase (see Table 8), but the evidence shows that the predictive
past monthly stock returns (six months), and use the median
power for returns is nonexistent in investment-grade stocks. The
value to divide the sample into high/low uncertainty groups. The
long-short portfolio based on short interest changes yields signifi-
columns 4 and 5 of Table 10 report the predictive regressions
cant abnormal returns for speculative-grade stocks, which is robust
of PM for high and low return volatility, respectively. The co-
to controlling for various cross-sectional effects. Based on these ob-
efficient of PM is -0.048 for the high return volatility group,
servations, one logical follow-up question is, why does the short
which is 11% lower than that for distressed firms (-0.054) in ab-
interest anomaly concentrate in speculative-grade firms?
solute terms. We also use idiosyncratic volatility as an alterna-
Speculative-grade or distressed firms differ from other firms in
tive proxy for uncertainty. The coefficient of PM is -0.043 for
several ways, which could explain the differential effects of short
stocks with high idiosyncratic volatility, which is 20% lower than
interest. First of all, if stock returns from distressed firms are more
the coefficient for distressed stocks. Unreported results show a
sensitive to earnings surprise, it will be more profitable for in-

Table 10
Changes in short interest ratio as a predictor of firms’ future profits.

Variables Full sample NIG IG Low Equity Volatility High Equity Volatility Low Idio. Volatility High Idio. Volatility

SIR -0.038∗ ∗ ∗ -0.054∗ ∗ ∗ -0.013 -0.038∗ ∗ -0.048∗ ∗ ∗ -0.020 -0.043∗ ∗ ∗

(-2.81) (-3.03) (-0.70) (-2.05) (-2.85) (-0.93) (-2.65)
Ln(size) 0.005∗ ∗ ∗ 0.003∗ ∗ ∗ 0.003∗ ∗ ∗ 0.004∗ ∗ ∗ 0.005∗ ∗ ∗ 0.003∗ ∗ ∗ 0.005∗ ∗ ∗
(47.61) (11.40) (31.69) (38.27) (36.84) (29.42) (36.81)
B/M -0.006∗ ∗ ∗ -0.005∗ ∗ ∗ -0.010∗ ∗ ∗ -0.008∗ ∗ ∗ -0.007∗ ∗ ∗ -0.011∗ ∗ ∗ -0.005∗ ∗ ∗
(-13.99) (-6.93) (-21.04) (-19.00) (-9.11) (-20.86) (-8.25)
r[- 0.017∗ ∗ ∗ 0.019∗ ∗ ∗ 0.015∗ ∗ ∗ 0.014∗ ∗ ∗ 0.018∗ ∗ ∗ 0.012∗ ∗ ∗ 0.018∗ ∗ ∗
6,- (16.21) (15.44) (14.82) (12.49) (15.46) (11.09) (15.95)
Constant
1] -0.072∗ ∗ ∗ -0.046∗ ∗ ∗ -0.043∗ ∗ ∗ -0.051∗ ∗ ∗ -0.075∗ ∗ ∗ -0.043∗ ∗ ∗ -0.073∗ ∗ ∗
(-41.30) (-13.06) (-24.92) (-31.21) (-33.03) (-22.68) (-33.80)
Observations 265,392 95,677 169,715 130,651 134,741 124,707 131,914
Avg R-squared 0.087 0.063 0.082 0.089 0.085 0.101 0.073

For each month t, we run cross-sectional regressions of firm profit margins (PM) for the next month on the change in short interest ratio and other controls:

P Mi,t+1 = αt + βt SIRit + Xt γt + et
PMi,t+1 is stock i’s profit margin in month t+1, measured by net income (NIQ) over sales (SALEQ). For quarterly profit margins ending in quarter q, all the three
months in that quarter are evenly assigned with the quarterly profit margin. SIRit is the change in short interest ratio for stock i from month t-1 to month
t. X is a vector of control variables including size, book to market ratio, and past six-month returns. Equity volatility is computed as the standard deviation of
past monthly stock returns (six months). Idiosyncratic volatility is the standard deviation of daily stock return residuals relative to the baseline factor model
over the past five years. Low/high equity/idiosyncratic volatility portfolios consist of stocks with equity/idiosyncratic volatility below/above the median. We
report the time-series average of these cross-sectional regression coefficients with their associated sample t-statistics (in parentheses). The sample period
runs from January 1986 to February 2017. The signs ∗ ∗ ∗ , ∗ ∗ , and ∗ indicate significance at the 1%, 5% and 10% levels, respectively.
 X. Guo and C. Wu / Journal of Banking and Finance 108 (2019) 105617
similar lower predictive power among stocks with high analyst
forecast dispersion. Thus, future profitability is more predictable
among distressed stocks than among other stocks with higher
uncertainty.
To directly investigate whether short sellers predict the re-
turns of distressed stocks because they are able to better predict
firms’ future profitability, we include as explanatory variables in
the return regression of Table 4 the change in future profitabil-
ity (PMt+1 ), as well as the interaction between the change in
future profitability and a dummy variable (PMt+1 x DSIRt(10) )
where the dummy variable has a value equal to one for stocks
in the lowest decile of short interest changes. Column 3 in each
set of regressions in Panel A of Table 4 reports the results for
the full sample and rating subsamples, respectively. The coefficient
of PMt+1 is significantly positive, consistent with the hypothesis
that stock returns reflect future firm profitability. The coefficient
of the interaction variable is also positive, suggesting that attenu-
ation of short sales predicts higher stock return through the chan-
nel of changes in the firm’s future operating performance. More
importantly, the coefficient of the interaction variable PMt+1
x DSIRt(10) is significantly positive for distressed stocks but in-
significant for investment-grade stocks. This finding suggests that
one possible channel of short interest predictive power is that
short sellers can better predict the future profitability of distressed
firms.
The above analysis improves our understanding of the informa-
tion content of credit ratings for distressed firms. The literature
has documented that credit ratings contain information about un-
certainty for firms’ future fundamentals, growth rates and cost of
capital, mispricing, limited future access to credit, and information
uncertainty due to fewer analysts following (see Avramov et al.,
2009a, 2013, 2017; Akbas et al., 2017). Adding to this literature, we
find that short interest changes convey information about the fu-
ture profitability of distressed firms.
6. Conclusion
This paper explores the role of firm-level distress risk in driv-
ing the predictive relation between short interest and future stock
returns. We first examine the effects of short interest levels and
credit ratings, and find that the well-established pattern of return
predictability is most evident in the group of speculative-grade
stocks. We then propose changes in short interest as an alterna-
tive return predictor, which is a detrended variable that better cap-
tures variations in short-sellers’ beliefs. We find that the predictive
power of short interest changes for future returns is stronger, and
return predictability is more pronounced for firms with a rating of
BB+ and below.
The long-short portfolio generates economically significant re-
turns for distressed stocks. For speculative-grade firms, a portfolio
that longs stocks with the largest decrease in the short interest ra-
tio (P1) and shorts stocks with the largest increase in the short in-
terest ratio (P10) delivers an abnormal return (alpha) of about 15%
per annum. The return predictability associated with short interest
changes is robust to controlling for various cross-sectional effects.
In contrast, the long-short portfolio generates no significant pay-
offs for investment-grade stocks.
We also investigate the economic sources of short interest pre-
dictive power for stock returns of distressed firms. We find that
stock returns are more sensitive to changes in a distressed firm’s
earnings, which increases the profitability of trading on informa-
tion in short interest. In addition, short interest changes predict
the future profitability of distressed firms. These findings provide
an explanation for why the short interest anomaly concentrates in
these firms.
13
Our study contributes to the current literature by uncov-
ering new evidence that the short interest anomaly is linked
to financial distress. We show that financial distress leads to
the high sensitivity of stock prices to changes in earnings and
drives the return predictability of short interest. Our results
confirm previous findings about the importance of firm-level
distress risk effects in asset pricing and lend support to the
argument that there exist commonalities across asset pricing
anomalies.
Supplementary materials
Supplementary material associated with this article can be
found, in the online version, at doi:10.1016/j.jbankfin.2019.105617.
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