A new study from George Mason University reveals that not only are there abnormally high levels of short-selling of NASDAQ stocks prior to the public release of analyst downgrades, but evidence suggests that the short-sellers are informed traders.
George Mason University finance professors Stephen Christophe, Michael Ferri and Jim Hsieh conducted the study, the first of its kind to consider the overall magnitude and significance of short-selling in the days preceding analyst downgrades.
"Research focusing on the practice of short-selling is growing, and we wanted to build on that literature by examining the pattern of short-selling around the time of downgrade announcements by analysts," says Christophe. "We found that the evidence appears to suggest that these short sellers are informed traders and are able to take advantage of information by trading shares before negative information is revealed to the public."
Evidence in the study supports what researchers refer to as the "tipping hypothesis," which states that informed trading arises because short sellers benefit from a tip they receive from insiders aware of a forthcoming downgrade announcement.
The fact that the evidence strongly supports the tipping hypothesis raises serious issues regarding whether some clients of certain brokerage firms benefit from material private information about upcoming downgrades. If this indeed is the case, both analysts and investors violate the principle that all market participants deserve fair and equitable treatment.
"Our findings imply that the activity alleged in the recent complaint by the Securities and Exchange Commission regarding tipping in the case of the brokerage subsidiary of UBS AG might have been quite common," says Christophe. "Thus, our work calls into question the fairness of the special treatment accorded to certain prominent groups of equity market participants, and this special treatment could be construed as a violation of SEC Rule 10b-5."
The study found that average daily short-selling three days prior to the downgrade date is about four times higher than its normal level and is significantly related to the subsequent negative share price reaction to the downgrade. Evidence suggests that this relationship is especially pronounced for downgrades that prompt the most substantial price declines.
About the School of Management
The School of Management (SOM) educates and empowers future generations of business leaders through world-class teaching, innovative academic programs and close partnerships with regional and global businesses. Established in 1971, SOM has grown rapidly in both its regional and international reputation. SOM prepares students for increased globalization through a range of academic programs and international alliances. It is one of only 170 business schools world-wide whose programs in both business and accounting are accredited by the Association to Advance Collegiate Business Schools International (AACSB). The latest U.S. News & World Report ranking of undergraduate business programs continues to place the George Mason University School of Management in the Top 100 out of 591 AACSB accredited schools worldwide. At the graduate level, the School of Management is one of only six business schools in the country to require international residences for its graduate students.
About George Mason University
George Mason University, located in the heart of Northern Virginia's technology corridor near Washington, D.C., is an innovative, entrepreneurial institution with national distinction in a range of academic fields. With strong undergraduate and graduate degree programs in engineering, information technology, biotechnology and health care, Mason prepares its students to succeed in the work force and meet the needs of the region and the world. Mason professors conduct groundbreaking research in areas such as cancer, climate change, information technology and the biosciences, and Mason's Center for the Arts brings world-renowned artists, musicians and actors to its stage. Its School of Law is recognized by U.S. News & World Report as one of the top 40 law schools in the United States.