(Bloomberg) — Somehow, the stock market’s worst first half in five decades has morphed into a slaughterhouse for short sellers.
More big lumps were felt Tuesday, when the S&P 500 rallied 2.8% and bearish traders suffered losses roughly double that.
About 98% of S&P 500 members advanced, the broadest rally since December 2018. The most-hated stocks jumped 5.5%, eventually delivering pain for bears who were forced to cover their positions to limit losses, going by a Goldman Sachs Group Inc. basket. With the most-shorted basket up 16% in July, the month is shaping up to be the worst for short sellers since the retail-driven squeeze in January 2021.
From a retreat in the dollar to signs of an easing energy crisis in Europe, pressures that were once weighing on equities have subsided. The stock rebound occurred on the same day a major survey of money managers pointed to a “full capitulation.” Extreme risk aversion may be what underlies rallies like this, according to Mark Freeman, chief investment officer at Socorro Asset Management LP.
“Positioning had gotten very defensive as managers were anticipating additional downside. However, if the market rallies, then they are at risk of underperforming the broader market,” Freeman said. “Shorts are hurting their performance and they don’t have enough long exposure to keep up so they are forced to buy.”
Broadly speaking, stocks performed in a perfect inverse relationship to their short holdings. That is, the higher a stock’s short interest, the better the return. Among Russell 3000 companies, the top quintile by short sales jumped 4.3% on average, compared with a 3% increase in the bottom group, data compiled by Bloomberg show.
It’s a sudden turn of fortune for short sellers, who just enjoyed their best gain since the 2008 financial crisis as stocks cratered into a bear market in the first half. Encouraged by what amounted to a rare success in the past decade, bears quickly ramped up bets. In the first six months of 2022, hedge funds raised their bearish wagers at the fastest pace in more than nine years, according to data from Goldman’s prime broker unit.
While bets on further selling have helped professional speculators such as hedge funds beat the market this year, the pessimism turns into a performance drag when sentiment shifts. And if positioning in futures among the speculators is any indicator, there are still a lot of shorts to cover should the current rebound prove more sustained than other attempts to rally so far this year.
As of last week, asset managers and leveraged funds were positioned short on equity futures by the most on record, according to Commodity Futures Trading Commission data compiled by Deutsche Bank AG.
Some computer-driven funds are already rushing to offload bets that selling will persist into the summer. In the past week, commodity trading advisors, funds that take long and short bets in the futures market, had bought about $33 billion of equities to cover their shorts, according to an estimate from Charlie McElligott, a cross-asset strategist at Nomura Holdings.
To Michael O’Rourke, chief market strategist at JonesTrading, it’s not unusual to see these rules-based funds chase the rally while fundamental-focused investors wait for evidence for confirmation. With S&P 500 valuations sitting near the long-term average and the Federal Reserve a long way from pausing its aggressive monetary tightening, O’Rourke is not convinced that this recovery can last. Stocks bounced significantly three other times this year. All led to fresh lows.
“The sharp equity market rallies would be understandable if valuation levels were attractive, or economic headwinds dissipated, or a Fed policy pivot occurred. None of those criteria appear close to being met,” said O’Rourke. “As it appears active managers have generally moved to the sidelines, inelastic model based players and passives wind up chasing the tape.”
Sentiment has deteriorated sharply this year as investors fret the Fed’s battle against red-hot inflation will drag the economy into a recession. Allocation to stocks plunged to levels last seen in October 2008 while exposure to cash surged to the highest since 2001, according to Bank of America’s monthly fund manager survey.
With signs emerging that inflation may be peaking, some investors may seek to frontrun others, diving into the market ahead of an eventual bottom, according to Chris Murphy, co-head of derivatives strategy at Susquehanna International Group.
“‘Everyone’ is underweight equities and overweight cash, ‘everyone’ expects earnings season to be terrible, but ‘everyone’ is waiting for the earnings reset to begin buying equities,” he said. “Given all that, some investors may be figuring ‘why wait?’”