Short-sale constraints and stock returns

Stocks can be overpriced when short-sale constraints bind. We study the costs of shortselling equities from 1926 to 1933, using the publicly observable market for borrowing stock. Some stocks are sometimes expensive to short, and it appears that stocks enter the borrowing market when shorting demand is high. We find that stocks that are expensive to short or which enter the borrowing market have high valuations and low subsequent returns, consistent with the overpricing hypothesis. Size-adjusted returns are 1-2% lower per month for new entrants, and despite high costs it is profitable to short them. (C) 2002 Elsevier Science B.V. All rights reserved.