Short sellers earn profits by betting on a part of the U.S. stock market that is overlooked by most investors: small-cap stocks.
The group has made a paper profit of nearly $13 billion this year by betting on a decline in the prices of small-, micro- and nano-cap stocks, according to an estimate by S3 Partners LLC based on the average number of short positions in the stock markets. market. That stands in stark contrast to losses of about $140 billion from short sales of mid-, mega- and large-cap stocks, which rose for much of the year as the economy defied gloomy forecasts and the Federal Reserve moved closer to termination of her interest came. Interest rate hikes and breakthroughs in artificial intelligence caused a rush in technology stocks.
The difference underlines the divide that opened up in the stock market as companies like Nvidia Corp., Meta Platforms Inc. and Tesla Inc. accounted for a large portion of the profits. More than half the stocks in the Russell 2000 — a benchmark for smaller companies — have fallen this year, leaving gains at 5%, far below the 16% gain in the S&P 500.
“Much of this year’s performance has been about AI enthusiasm, which disproportionately benefited the largest tech stocks,” said Steve Sosnick, chief strategist at Interactive Brokers. “So far it’s been a top-down series of winners.”
Small-cap stocks participated in the stock market rally from June to July. But they have been hit hardest during the recent pullback, with about $9.7 billion in estimated profits from short sellers since August, according to S3 data.
With stocks battered, investors withdrew $1.5 billion from funds focused on the segment last week, the most in nearly three months, according to Bank of America Corp. strategists, citing EPFR Global. In contrast, US large-cap stock funds raised $5.5 billion.
One reason for the underperformance is sector weightings that have curbed interest as investors focus heavily on certain sectors, said Rob Haworth, senior investment strategist at US Bank Wealth Management. The group has little exposure to technology, the best-performing corner of the market this year, and heavier weights in finance and energy, some of the worst laggards. Small businesses are also hit hardest by economic slowdowns and tighter monetary policy.
“They are often also the companies that bear the brunt of stricter credit standards and stricter lending standards,” Haworth said. “I think this has kind of created an environment that puts a lot of pressure on small caps.”
Morgan Stanley’s Mike Wilson, who has predicted a stock market decline, has similarly warned investors to stay away from small-cap stocks, whose profit margins are at greater risk of being eroded by inflation.
According to S3, bets on small-cap stocks represent less than 10% of all short selling. And some strategists predict that small caps have room to recover. For example, Bank of America’s Jill Carey Hall has said that segments of the market that have priced in the risk of a recession are most likely to outperform if the economy continues to grow.
Yet short sellers are still coming in. In the past 30 days, they have invested $658 million in bets against small caps, an increase from the previous month, according to S3. The group has bet the most money against Archer Aviation Inc., Air Transport Services Group Inc, Alteryx Inc. in the past month. and Sage Therapeutics Inc., S3 data shows.
The most profitable small cap shorts so far this year have been beaten regional banks. The bets against Lumen Technologies Inc., Foot Locker Inc. and Beam Therapeutics Inc. also paid off, according to S3.