TL;DR:
- Short sellers have profited significantly, earning $13 billion this year by betting against small-cap stocks.
- This stands in contrast to their losses of around $140 billion from short sales of mid, mega, and large-cap stocks.
- The stock market has seen a divergence, with tech giants like Nvidia Corp. and Meta Platforms Inc. driving gains while over half of small-cap stocks in the Russell 2000 index have declined.
- AI enthusiasm and top-down dynamics have favored larger tech stocks, leaving small caps vulnerable.
- Small-cap stocks have faced the brunt of the recent market pullback, resulting in $9.7 billion in short-sellers’ estimated profits since August.
- Investor sentiment reflects this trend, with $1.5 billion withdrawn from small-cap-focused funds, in contrast to a $5.5 billion inflow into US large-cap stock funds.
- Sector weightings, economic vulnerabilities, and the threat of inflation have contributed to small caps’ underperformance.
- Despite short-sellers’ focus on small caps, their bets constitute less than 10% of all short selling.
- Some strategists remain optimistic about small caps rebounding, especially if the economy continues to grow.
Main AI News:
Short sellers have pocketed a staggering $13 billion in profits this year, capitalizing on a segment of the US equity market that has largely gone unnoticed by mainstream investors: small-cap stocks. According to estimates from S3 Partners LLC, short sellers have reaped these substantial gains by betting on the decline of small, micro, and nano-cap shares.
This success stands in stark contrast to the roughly $140 billion in losses incurred by short sales of mid, mega, and large-cap stocks. These larger stocks rallied throughout the year, defying gloomy economic forecasts. As the Federal Reserve inched closer to ending its interest-rate hikes and breakthroughs in artificial intelligence triggered a tech stock frenzy, short sellers found themselves on the wrong side of the trade.
This divergence underscores the unique dynamics at play in the stock market, where companies like Nvidia Corp., Meta Platforms Inc., and Tesla Inc. led the way in driving substantial gains. Over half of the stocks listed in the Russell 2000, a gauge of smaller companies, have experienced declines this year, limiting its overall gain to a mere 5%, well below the S&P 500’s impressive 16% surge.
According to Steve Sosnick, Chief Strategist at Interactive Brokers, “So much of this year’s performance has been about AI enthusiasm, which disproportionately benefitted the largest tech stocks. It’s been a top-down set of winners so far.”
While small-cap stocks initially joined the broader equity market rally from June through July, they have faced the brunt of the recent market pullback. Data from S3 Partners shows that short sellers have reaped an estimated $9.7 billion in profits since August.
Investor sentiment has also reflected this downturn, with $1.5 billion withdrawn from funds focused on small-cap stocks last week, marking the largest outflow in nearly three months. In contrast, US large-cap stock funds saw an inflow of $5.5 billion during the same period, as reported by Bank of America Corp. strategists, citing EPFR Global.
Several factors have contributed to the underperformance of small-cap stocks. Their sector weightings have played a crucial role, with investors heavily favoring specific industries, particularly technology, which has been the best-performing sector this year. Small caps carry heavier weightings in finance and energy, sectors that have lagged behind. Additionally, smaller companies are more vulnerable to economic slowdowns and tightening monetary policies.
Rob Haworth, Senior Investment Strategist at US Bank Wealth Management, noted, “They also tend to be the companies that take the brunt of tighter credit conditions and tighter lending standards. I think that’s kind of created this environment that’s put a lot of pressure on small caps.”
Morgan Stanley’s Mike Wilson, a proponent of a stock-market decline, has echoed these concerns, advising investors to steer clear of small-cap stocks due to their higher susceptibility to inflation eroding profit margins.
While short sellers have targeted small caps, their bets make up less than 10% of all short selling, according to S3. Some strategists remain optimistic about the potential for small caps to rebound. Bank of America’s Jill Carey Hall, for instance, believes that segments of the market pricing at the risk of a recession are most likely to outperform if the economy continues to grow.
Despite these prospects, short sellers continue to pour in, increasing their positions by $658 million in the last 30 days alone, according to S3 data. Notably, they have concentrated their efforts on Archer Aviation Inc., Air Transport Services Group Inc., Alteryx Inc., and Sage Therapeutics Inc., anticipating further declines.
This year’s most lucrative small-cap short trades have centered around beleaguered regional banks, while bets against Lumen Technologies Inc., Foot Locker Inc., and Beam Therapeutics Inc. have also paid off handsomely, as per S3 data.
Conclusion:
Short sellers’ success in profiting from declining small-cap stocks highlights the significant influence of the tech sector and sector weightings on market performance. The shift towards larger tech companies and the vulnerability of small caps to economic conditions raise concerns. Investors and analysts should closely monitor these trends to navigate the evolving market landscape effectively.
