Short sellers make profits by shorting a segment of the U.S. stock market that is ignored by most investors: small-cap stocks.
The group has made nearly $13 billion in paper profits this year by betting on price declines in small-cap, micro-cap and ultra-small stocks, according to S3 Partners LLC estimates based on the average number of short positions in small-cap, micro-cap and ultra-small stocks. . market. That contrasts with about $140 billion in losses from short selling in mid-cap, mega-cap and large-cap stocks, which have risen for much of the year as the economy defied downbeat expectations and the Federal Reserve neared the end of its rate hikes. Rise in interest rates and breakthroughs in artificial intelligence spark panic in tech stocks.
The disparity highlights a chasm emerging in the stock market as companies such as Nvidia Corp., Meta Platforms Inc. and Tesla Inc. drove much of the gains. More than half the stocks in the Russell 2000 index, a measure of smaller companies, have fallen this year, holding its gains to 5%, well below the S&P 500’s 16% gain.
“A lot of this year’s performance has to do with enthusiasm for artificial intelligence, which has benefited the largest technology stocks,” said Steve Sosnick, chief strategist at Interactive Brokers. It’s been a top-to-bottom set of winners so far.”
From June to July, small-cap stocks joined the stock market’s rally. But they have been hardest hit by the recent pullback, with short sellers making an estimated profit of about $9.7 billion since August, according to S3 data.
Investors pulled $1.5 billion from funds focused on the sector last week, the highest level in nearly three months, as share prices took a beating, Bank of America strategists said, citing EPFR Global. By comparison, U.S. large-cap funds pulled in $5.5 billion.
Rob Haworth, senior investment strategist at Bank of America Wealth Management, said one reason for the underperformance is that industry weighting dampens investor interest as investors focus on specific industries. The group has little investment in technology, which has been the best-performing sector this year, while financials and energy, which are heavily weighted, are among the laggards. Small businesses are also among those hardest hit by the economic slowdown and tighter monetary policy.
“They also tend to be the companies that bear the brunt of tighter credit conditions and tighter lending standards,” Haworth said. “I think that creates an environment that puts a lot of pressure on small-cap stocks.”
Morgan Stanley’s Mike Wilson, who has been predicting a decline in stocks, has similarly warned investors to stay away from small-cap stocks, whose profit margins are more vulnerable to inflation.
S3 data shows that bets against small-cap stocks account for less than 10% of all short sales. Some strategists predict small-cap stocks have room to rebound. For example, those parts of the market that have priced in the risk of a recession are most likely to outperform if the economy continues to grow, said Jill Carey Hall of Bank of America.
However, short sellers are still piling in. In the past 30 days, they invested $658 million shorting small-cap stocks, an increase from the previous month, according to S3 data. The group made the largest bets last month on Archer Aviation Inc., Air Transport Services Group Inc., Alteryx Inc. and Sage Therapeutics Inc., S3 data showed.
The most profitable short trade in small-cap stocks so far this year has been among hard-hit regional banks. Bets on Lumen Technologies Inc., Foot Locker Inc. and Beam Therapeutics Inc. also paid off, according to S3.