Short Sale Constraints and Stock Misvaluation: Daily Evidence on the Nasdaq

In this paper I investigate the impact of short sale constraints on stock returns using Regulation SHO data on the NASDAQ in 2005. Extant theories suggest that removing the bid-price test rule on the NASDAQ for the so called ‘pilot stock’ would mitigate stock overvaluation. The results in this paper, however, show that lifting the bid-price test rule on the NASDAQ goes beyond correcting such overvaluation. Prices of stocks with the high degree of investor disagreement tend to be depressed relative to prices of stocks with low degree of investor disagreement during the sample period. This surprising result raises the concern that SEC’s recent decision of removing the bid-price test rule for NASDAQ listed securities may not be considered as an optimal policy, if such undervaluation is driven by ‘predatory’ short sellers’ price manipulation.