The market’s comeback in 2023 has been very bad news for one group: short sellers.
Short sellers profit from stock declines by borrowing shares of companies that they believe are overvalued, selling them, and then buying them back at a lower price later. They made huge gains in 2022, when markets around the world tumbled.
But their fortunes have reversed in January as the stock market has clawed back some of its losses.
A Goldman Sachs index tracking the 50 most shorted stocks in the Russell 3000 has returned 15% so far this year through Thursday, substantially outperforming the S&P 500, which is up 6%. Other stocks that got crushed in 2022 have also raced higher. Tesla Inc., coming off its worst year on record, has staged a 44% January rally. Meanwhile, money-losing cryptocurrency exchange Coinbase Global Inc. is up 73%.
Short sellers who have incurred hefty losses are actively trimming their positions, said Ihor Dusaniwsky, managing director of predictive analytics at S3 Partners. Investors betting against stocks have racked up $81 billion of mark-to-market losses on short positions this month through Thursday after accumulating $300 billion in gains in 2022, Mr. Dusaniwsky said.
Investors and analysts say the rally appears to be driven by a few things. Signs that inflation is cooling have stoked bets among investors that the Federal Reserve will pivot from raising interest rates to cutting them as soon as the second half of the year. That has helped risky assets across the board rise. Especially risky corners of the market, such as stocks with high short interest, have rallied even more. Analysts say that has likely forced short sellers to close out bearish positions to cut their losses — resulting in what is known on Wall Street as a short squeeze.
“We’re seeing a mirror image of the performance within the equity market. The worst performers last year have been leading this year,” said David Lefkowitz, head of Americas equities at UBS Global Wealth Management. “It does look like some re-risking and short covering.”
Investors will get their next update from the Fed on Wednesday, when the central bank concludes its first two-day policy meeting of the year. The Fed is expected to raise interest rates by a quarter of a percentage point, marking a slowdown from last year’s pace.
Some investors are warning that a prolonged rally of speculative assets could loosen financial conditions all over again and set back the Fed’s fight against inflation. Others say a rally driven in part by a short squeeze looks vulnerable to a swift reversal, should the Fed prove to be more aggressive on monetary policy than investors expect.
“People are now more willing to price in the soft landing,” Mr. Lefkowitz said. “What I still struggle with is, how does the Fed react to this? Can we really get inflation down to the Fed’s target if growth remains more robust than what markets were thinking just a few weeks ago?”
Investors who have grown more optimistic about the market’s prospects say data suggest that their worst-case scenario, a deep and prolonged recession, appears less likely than it did before.
The U.S. economy has so far proven resilient in the face of multiple rate increases. Gross domestic product grew at a solid 2.9% annual rate in the fourth quarter, the Commerce Department said Thursday, a slowdown from the third quarter but faster than what economists had expected.
Investors are also pointing to a strong U.S. labor market and the reopening of China as reasons for the market’s change in fortune so far this year. For investors looking to shift capital out of the defensive positions that were so popular in 2022, the battered technology sector has been a favorite place to start.
Even after its recent rally, the Nasdaq Composite looks cheap relative to its valuation during the pandemic rally, trading at a multiple of about 22 times earnings over the past 12 months, according to FactSet. That compares with a recent peak valuation of almost 37 times earnings in February 2021.
“We think that there’s a lot of relative value in how beaten up some of these mega technology companies were in 2022,” said Nicole Webb, senior vice president and financial adviser at Wealth Enhancement Group.
Ms. Webb added that technology stocks look compelling because they are likely to particularly benefit should the Fed start to ease monetary policy.
Traders in interest-rate derivatives markets see a 92% chance that the Fed lifts rates at least twice in the first half of the year, according to CME Group. They then see an 82% chance that the Fed cuts rates at least once by December, despite Fed officials indicating they don’t see any rate cuts happening this year.
Bond traders are also betting that the Fed will take rates lower. The 10-year Treasury yield has dropped to about 3.5% from a recent peak of 4.2% in October.
The pullback in bond yields has been good news for technology stocks in particular. Tech stocks often hold the promise of big profits but only in the future. That means they tend to do best when rates are low and investors have fewer plain-vanilla options for earning yield. They are often considered a high duration risk, meaning they have high sensitivity to interest rates over time.
“A lot of these stocks rallying were highly shorted, long duration names with earnings way out in the future. With a significant decline in the discount rate, those earnings are now worth more,” said Sameer Bhasin, principal at 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 hit the brakes on tightening policy without inflicting more pain on markets.
“I think the inflation scars are too significant today for them to feel comfortable cutting rates,” said Jason Brady, chief executive of Thornburg Investment Management.
Fed Chair Jerome Powell has said the central bank wants to avoid repeating its mistake from the 1970s, when policy makers cut rates too early — resulting in a prolonged period of runaway inflation and uneven growth.
“When they cut rates, it’s going to be because there’s real weakness in the economy,” Mr. Brady said.