Business

Short Sellers Profit from Bearish Bets on Small Cap Stocks Amid Market Disparities

Picture Source: GettyImages

Short sellers in the US equity market have been quietly capitalizing on profits by betting against a segment of the market that often flies under the radar: small-cap stocks. In a year characterized by remarkable market performance, these short sellers have reaped nearly $13 billion in paper profits by wagering on the decline of small-cap, micro-cap, and nano-cap shares. This trend contrasts sharply with the approximately $140 billion in losses from short sales of mid-cap, mega-cap, and large-cap stocks, which experienced significant rallies amid an economy defying predictions and a surge in tech stocks driven by advancements in artificial intelligence.

Small-Cap Struggles Amidst Top-Heavy Gains

The stark difference in performance underscores the market divide that emerged in 2023, with companies like Nvidia Corp., Meta Platforms Inc., and Tesla Inc. driving much of the gains. Over half of the stocks in the Russell 2000 index, which represents smaller companies, have witnessed declines this year, resulting in a modest 5% gain for the index compared to the S&P 500’s 16% surge.

Steve Sosnick, Chief Strategist at Interactive Brokers, commented on the year’s performance, stating, “So much of this year’s performance has been about AI enthusiasm, which disproportionately benefitted the largest tech stocks. It’s been a top-down set of winners so far.”

Recent Struggles for Small-Caps

Small-cap stocks did participate in the broader equity market rally from June through July. However, they have faced significant challenges during the recent market pullback, leading to an estimated $9.7 billion in profits for short sellers since August, according to data from S3 Partners LLC.

Investors have reacted to these challenges by withdrawing $1.5 billion from funds focused on small-cap stocks in the past week, marking the largest outflow in nearly three months, as per Bank of America Corp. strategists, citing EPFR Global data. In contrast, US large-cap stock funds attracted $5.5 billion during the same period.

Factors Contributing to Small-Cap Underperformance

Several factors have contributed to the underperformance of small-cap stocks, including sector weightings that have hindered investor interest. These stocks have relatively little exposure to the technology sector, which has been the best-performing segment of the market in 2023. Instead, they are heavily weighted in finance and energy sectors, which have lagged behind. Moreover, small companies are more vulnerable to economic slowdowns and tighter monetary policies.

Rob Haworth, a Senior Investment Strategist at U.S. Bank Wealth Management, explained, “They also tend to be the companies that take the brunt of tighter credit conditions and tighter lending standards. I think that’s kind of created this environment that’s put a lot of pressure on small caps.”

Mixed Sentiments and Future Outlook

Some market analysts, like Morgan Stanley’s Mike Wilson, who has predicted a stock-market decline, have advised investors to steer clear of small-cap stocks. Wilson cited the greater susceptibility of small-cap firms to profit margin erosion due to inflation.

However, not all market experts share this pessimistic view, and some predict that small caps have room for a rebound. Bank of America’s Jill Carey Hall, for instance, has argued that market segments pricing in the risk of a recession are likely to outperform if the economy continues to grow.

Read More: TikTok Shop: A New Marketplace Raises Questions Amid Early Rollout

Despite these differing opinions, short sellers have continued to bet against small-cap stocks, pouring $658 million into such bets over the past 30 days, according to S3 data. Notably, the short sellers have targeted companies like Archer Aviation Inc., Air Transport Services Group Inc., Alteryx Inc., and Sage Therapeutics Inc. in their recent moves.

The most profitable short trades among small-cap stocks this year have often been in struggling regional banks. Successful short bets against Lumen Technologies Inc., Foot Locker Inc., and Beam Therapeutics Inc. have also contributed to short sellers’ profits, as indicated by S3 data.

Leave a Reply

Your email address will not be published. Required fields are marked *