The ability of short-sale volume (SSV) to predict returns is closely related to price pressure from mutual funds (MFs). Daily directional trading by MFs is highly-persistent and price-destabilizing, leading to return reversals lasting months. At the same time, SSV reacts strongly in the opposite direction – when MFs buy (sell), SSV increases (decreases). Daily SSV is responsive to both the expected component of MF trades (based on prior days’ trading), and the unexpected component (based on same-day trading). Furthermore, SSV-strategies only predict returns when MFs are trading in the opposite direction. We conclude some short-sellers are strategic liquidity providers who detect and respond to price-destabilizing MF trades.
