Wall Street speculators have faced significant challenges with bets against U.S. stocks in the recent past. According to Goldman Sachs' (NYSE:GS) prime brokerage data, hedge funds underwent the most rapid rate of closing short positions and reducing risk in years, with the cumulative amount of short covering in June and July being the largest two-month stretch since 2016. Short sellers aim to profit from a decrease in the price of a stock. However, the U.S. stock market rally has been against the tide, forcing many short sellers to purchase the stocks at elevated prices, further propelling the rally.
Amidst this bullish scenario, U.S. and Canadian equity short sellers registered mark-to-market losses of $53.5 billion in July alone, and a cumulative $175.2 billion for the year. While every sector recorded losses for short sellers in July, there was a particular skepticism surrounding the rally, primarily given the soaring valuations of significant tech firms driving the market gains.
Hedge funds, having missed the unexpected market rally earlier in the year, have now resorted to higher leverage to amplify returns, with the pressure being on them to deliver substantial returns to justify their high fees in an environment of elevated interest rates.
Prominent figures, like billionaire Carl Icahn, shared their bearish sentiments on the market and the consequent negative impact on their investments. Icahn Enterprises (IEP) under attack from activist short sellers, has seen its stock plunge by 53% this year.
Mike Edwards from Weiss Multi-Strategy Advisers mentioned that the hefty, short covering in July was a considerable setback for many funds. This sentiment was further echoed with major banks revealing more optimistic market forecasts, and JPMorgan Chase (NYSE:JPM) announcing they no longer foresee a recession in 2023.
Goldman Sachs noted a 32% surge in their index of the 50 most shorted U.S. stocks in June and July, in contrast to the S&P 500's 9.8% rise. This year, long-short equity hedge funds have lagged behind the benchmarks, primarily due to losses from short sales.
Even as short covering has reduced hedge fund leverage from its peak this year, leverage levels remained notably high in late July. Alex Chaloff from Bernstein Private Wealth Management highlighted the risks of such heavy leveraging, which while fueling the current market rally, could jeopardize it if things go awry.
This article was originally published on Quiver Quantitative