A popular explanation for why Internet stocks were overpriced during 1999-2000 is that it was difficult to sell these stocks short. As the theory goes, if you can’t bet against the stocks through short sales, stock prices will only reflect the opinion of the most optimistic investors and will be overpriced.
It’s an appealing idea. But, according to Finance Professors Robert Battalio and Paul Schultz, it’s just not true.
By studying the same-day option price data from the peak of the Nasdaq bubble, they were able to closely compare actual stock prices with prices for shares created with options. They found no deviations suggesting short sell constraints.
Clearly, the study shows that investors could have sold these Internet stocks short if they had wanted to. Alternatively, investors could have sold short using options, and it wouldn’t have been expensive for them to do so.
So why didn’t smart investors sell short to profit from overpriced Internet stocks?
Battalio and Schultz suggest that the overpricing was simply not as obvious to traders then as it is to us now with the benefit of hindsight.
To learn more about the research of Professors Robert Battalio and Paul Schultz, who is the John W. and Maude Clark Professor of Finance, visit business.nd.edu/robertbattalio and business.nd.edu/paulschultz.