Rapach, Ringgenberg & Zhou (2016): Short Interest Predicts Stock Returns

#The Paper at a Glance

Title: Short interest and aggregate stock returns

Authors: David E. Rapach, Matthew C. Ringgenberg, and Guofu Zhou

Published: Journal of Financial Economics, 2016

DOI: 10.1016/j.jfineco.2016.03.004

Most return prediction research focuses on individual stocks. This paper asked a broader question: can you predict the overall stock market? The answer is yes—and the best predictor is short interest.

#What the Paper Found

Aggregate Return Prediction

The authors tested every major return predictor from the academic literature:

Short interest dominates every other predictor by a wide margin. An out-of-sample R-squared of 13.24% is extraordinary in financial forecasting.

Why Short Interest Predicts Returns

The logic is straightforward:

1. 1Short selling is costly and risky — you need to borrow shares, pay fees, and face unlimited loss potential
2. 2Only informed investors bother — the costs ensure short sellers have done extensive research
3. 3High aggregate short interest = market overvaluation — when informed traders collectively bet against stocks, it signals the market is expensive
4. 4Low aggregate short interest = healthier market — when short sellers can't find targets, valuations are more reasonable

Individual Stock Returns

The prediction works at the stock level too:

Stocks with the lowest short interest outperform those with the highest by nearly 10% per year.

#Who Are Short Sellers?

Short sellers aren't random speculators. Research consistently shows they are among the most informed participants in the market:

What Makes Them Special

• Sophisticated institutional investors — hedge funds, proprietary trading firms
• Fundamental analysts — they identify overvaluation through deep research
• Contrarians by nature — willing to bet against the crowd

Supporting Evidence

• Boehmer, Jones & Zhang (2008): Institutional short sales are highly informative about future returns
• Dechow et al. (2001): Short sellers target stocks with poor fundamentals (high accruals, declining profitability)
• Gorbenko (2023): Short interest predicts returns in 24 of 32 countries studied

#The Information Advantage

Why do short sellers know more than the average investor?

1. Higher Bar for Entry

To short a stock, you must: - Find shares to borrow (not always possible) - Pay borrowing fees (0.5-10% annually) - Post margin collateral - Face unlimited loss potential

This high bar means short sellers only act when they have high conviction.

2. Research Intensity

Because the costs are so high, short sellers do extensive research: - Forensic accounting analysis - Channel checks with industry contacts - Supply chain analysis - Management quality assessment

3. Willingness to Be Contrarian

Most investors are long-only and optimistic. Short sellers are willing to go against the crowd—and the evidence shows they're often right.

#How This Applies to Our Rankings

Short interest is our sixth factor, weighted at 10% in the composite score.

We use it as a negative screen rather than a primary return driver: - Low short interest = positive signal (smart money isn't betting against you) - High short interest = warning flag (sophisticated investors see problems)

We measure short interest using the "days to cover" ratio:

Days to Cover = Shares Sold Short / Average Daily Volume

Higher days-to-cover suggests more bearish sentiment and potentially more negative information not yet reflected in prices.

The 10% weight reflects that short interest is a valuable signal but is more useful as a risk screen than as a standalone factor. It helps us avoid stocks where informed investors have identified fundamental problems.

See stocks with lowest short interest →

#Academic Source

Rapach, D. E., Ringgenberg, M. C., & Zhou, G. (2016). "Short interest and aggregate stock returns." Journal of Financial Economics, 121(1), 46-65.