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Alex Castaldo contributes to Short Selling Thread:
Paul Asquith, then at Harvard and now at MIT, was the author of the famous paper many
years ago that claimed that stocks that are heavily shorted under perform in the
University endowments were enthusiastic about the idea and you
predicted that it would not work.
In his latest paper, dated just a few days ago, he qualifies his findings somewhat:
1. The effect shows up for Equal Weighted but not for Value Weighted portfolios, which suggests that it is confined to Small Cap stocks and is absent or reduced for Big Stocks.
2. A new variable, Institutional Ownership, is important. It is the stocks having low institutional ownership which under perform when they are heavily shorted. Asquith explains this by saying that stocks that are heavily owned by institutions are the ones that are easy to borrow/short (presumably the institutions lend the stocks to would be borrowers). When a stock is easy to borrow Short Sales are not a predictor of future returns. But when a stock is difficult to borrow (low institutional ownership) and yet someone goes to the trouble of borrowing/shorting it, THOSE ARE THE ONES that will have low returns going forward. However this situation is uncommon (20 out of 5500 stocks in their sample) and for the majority of stocks short sales are not a good predictor.
3. There are differences on the behavior of shorted stocks on NYSE vs. Amex vs. Nasdaq.
In summary Asquith has moved somewhat towards your position by backtracking partially from his earlier conclusion.