The market’s comeback in 2023 was very bad news for one group: short sellers.
Short sellers profit from stock falls by borrowing shares of companies they believe are overvalued, selling them, and later buying them back at a lower price. They made huge profits in 2022, as markets around the world collapsed.
But their fortunes reversed in January as the stock market recovered some of its losses.
A Goldman Sachs index that tracks the 50 stocks with the most short positions in the Russell 3000 has returned 15% so far this year through Thursday, significantly outperforming the S&P 500, which is up 6%. Other stocks that were crushed in 2022 have also raced higher. Tesla Inc.,
after having its worst year ever, it rallied 44% in January. Meanwhile, money-losing cryptocurrency Coinbase Global is trading Inc.
increases by 73%.
Short sellers who have suffered heavy losses are actively reducing their positions, said Ihor Dusaniwsky, managing director of predictive analytics at S3 Partners. Investors betting against stocks have suffered $81 billion in market value losses on short positions this month through Thursday, having accrued $300 billion in profits by 2022, Mr Dusaniwsky said.
Investors and analysts say the rally appears to be driven by a few things. Signs that inflation is cooling down have fueled bets among investors that the Federal Reserve will reverse interest rates from hikes to cuts as early as the second half of the year. That has helped risky assets rise across the board. Particularly risky parts of the market, such as stocks with high short-term interest rates, have risen even more. Analysts say this likely forced short sellers to close bearish positions to cut their losses, resulting in what is known on Wall Street as a short squeeze.
“We are seeing a mirror image of stock market performance. Last year’s worst performers led this year,” said David Lefkowitz, head of Americas Equities at UBS Global Wealth Management. “It looks like some re-risks and short coverage.”
Investors will get their next update from the Fed on Wednesday, as the central bank wraps up its first two-day policy meeting of the year. The Fed is expected to raise rates by a quarter of a percentage point, a slowdown from last year’s pace.
Some investors warn that a prolonged rally in speculative assets could ease financial conditions again and slow the Fed’s fight against inflation. Others say a rally driven in part by a short squeeze looks vulnerable to a quick reversal should the Fed prove more aggressive on monetary policy than investors expect.
“People are now more willing to praise the soft landing,” said Mr. Lefkowitz. “What I’m still struggling with is, how is the Fed responding to this? Can we really bring inflation back to the Fed’s target if growth continues to be more robust than what the markets thought a few weeks ago?
Investors who have become more optimistic about the market outlook say data suggests their worst-case scenario, a deep and prolonged recession, seems less likely than before.
The US economy has so far proved resilient despite multiple rate hikes. Gross domestic product grew at a solid 2.9% year on year in the fourth quarter, the Commerce Department said Thursday, a slowdown from the third quarter but faster than economists had expected.
Investors also point to a strong US job market and China’s reopening as reasons for the market’s change so far this year. For investors looking to move capital out of the defensive positions that were so popular in 2022, the battered technology sector is a favorite place to start.
Even after the recent rally, the Nasdaq Composite looks cheap relative to its valuation during the pandemic rally, at a multiple of about 22 times its earnings over the past 12 months, according to FactSet. That compares to a recent peak valuation of nearly 37 times earnings in February 2021.
“We think there is a lot of relative value in how beat up some of these mega tech companies were in 2022,” said Nicole Webb, senior vice president and financial advisor at Wealth Enhancement Group.
Ms. Webb added that technology stocks look attractive because they are most likely to benefit if the Fed starts easing monetary policy.
Traders in interest rate derivatives markets see a 92% chance that the Fed will raise rates at least twice in the first half of the year, according to CME Group. They then see an 82% chance that the Fed will cut rates at least once in December, despite Fed officials saying they don’t see rate cuts happening this year.
Bond traders are also betting that the Fed will cut interest rates. The 10-year Treasury yield has fallen to around 3.5% after a recent peak of 4.2% in October.
The fall in bond yields is particularly good news for technology stocks. Tech stocks often promise big profits, but only in the future. That means they tend to do best when interest rates are low and investors have less common options for getting returns. They are often considered to have high maturity risk, meaning they are highly sensitive to interest rates over time.
“Many of these stocks that were on the rise were very short term names with long maturities and earnings well into the future. With a significant drop in the discount rate, that income is now worth more,” said Sameer Bhasin, director of Value Point Capital, a New York-based family office.
Still, other investors remain skeptical of the Goldilocks view that the Fed can curb inflation and ease tightening without further hurting markets.
“I think the scars from inflation are too big today to feel comfortable lowering rates,” said Jason Brady, CEO of Thornburg Investment Management.
Fed Chair Jerome Powell has said the central bank wants to avoid repeating its mistake of the 1970s, when policymakers cut rates too early, resulting in a prolonged period of runaway inflation and uneven growth.
“If they cut interest rates, it will be because the economy is really weak,” Brady said.
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