Shorting activity and stock return predictability: Evidence from a mandatory disclosure shock

Abstract

We study the effect of a mandatory improvement in public disclosure due to the adoption of International Financial Reporting Standards (IFRS) on the stock return predictability of shorting activity. To assess the impact of the disclosure shock, we measure monthly changes in the demand for and supply of stocks for shorting and whether those changes predict negative returns in the following month. We provide international evidence that the ability of increases in shorting demand and supply to predict negative returns declines after the shock. The predictive ability of shorting in the month before a negative earnings surprise and news of a firm's questionable merger and acquisitions transaction also declines after the shock. These findings imply that the shock of the mandatory accounting change crowds out some of short-sellers’ value-relevant information in the equity lending market. Thus, although the democratization of information from a structured accounting change may make sophisticated investors worse off by reducing their ability to predict future returns, this change may also benefit all investors through timely stock price discovery.