Divergence of opinions, short sales, and asset prices

Prior research has established that stocks with high dispersion of earningsforecasts or short interest are associated with low subsequent returns. Assumingdispersion of forecasts is a proxy for divergence of opinions and short interest is a proxyfor short selling constraints, these results have been traditionally attributed to correctionfor overpricing created by binding short selling constraints. This argument is provided byMiller (1977), and states that prices reflect an optimistic view when investors withpessimistic views can not trade due to short selling constraints, and that the moreopinions diverge, the more stocks become overpriced. I test whether dispersion offorecasts exacerbates overpricing, but find evidence contrary to Miller’s theory. Whendispersion of forecasts increases, prices decrease. I offer an explanation based onanalysts’ reluctance to quickly revise their forecasts downward. I show that someanalysts’ sluggish response to bad news results in dispersion of forecasts. The inertia indownward forecast revisions also leads to market underreaction to bad news. Therefore,the negative relationship between dispersion and subsequent returns may be attributableto analysts’ sluggish response to bad news. I also examine the return predictability offirms with high short interest and low institutional ownership. Short interest seems topredict not only future stock returns but also future earnings news, especially for firmswith lower institutional ownership. Therefore, the return predictability of short interestseems to be associated with value relevant information short sellers seem to havegathered.