Short sellers see $13B win with often overlooked equities

Sometimes taking the road less traveled proves profitable.

Short sellers are raking in profits by betting against a part of the US equity market overlooked by most investors: small-cap stocks.

The group has seen paper profits of nearly $13 billion this year by wagering on a drop in the prices of small-, micro- and nano-cap shares, according to an estimate by S3 Partners LLC based on the average amount of short positions in the market. That’s in stark contrast to the roughly $140 billion in losses from short sales of mid-, mega- and large-cap stocks, which rallied for much of the year as the economy defied gloomy forecasts, the Federal Reserve edged closer to ending its interest-rate hikes and breakthroughs in artificial intelligence triggered a stampede in tech stocks.

The difference underscores the gulf that opened up in the stock market as companies like Nvidia Corp., Meta Platforms Inc. and Tesla Inc. drove much of the gains. More than half of the stocks in the Russell 2000 — a gauge of smaller companies — have dropped this year, holding it to a 5% gain, far below the 16% jump in the S&P 500.

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

The small-caps stocks joined in the equity-market rally from June through July. But they’ve been hit hardest during the recent pullback, with about $9.7 billion of short-sellers’ estimated profits emerging since August, according to S3’s data.

With the shares 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. By contrast, US large-cap stock funds pulled in $5.5 billion.

One reason for the underperformance is sector weightings that have curbed interest as investors focus heavily on particular industries, said Rob Haworth, a senior investment strategist at U.S. Bank Wealth Management. The group has little exposure to technology, the best-performing corner of the market this year, and heavier weightings in finance and energy, some of the worst laggards. Small companies are also the most heavily affected by economic slowdowns and tighter monetary policy.

“They also tend to be the companies that take the brunt of tighter credit conditions and tighter lending standards,” Haworth said. “I think that’s kind of created this environment that’s put a lot of pressure on small caps.”

Morgan Stanley’s Mike Wilson, who has been predicting a stock-market decline, has similarly warned investors to stay away from small-cap stocks, whose profit margins are more highly at risk of being eroded by inflation.

The bets against small cap stocks makes up less than 10% of all short selling, according to S3. And some strategists predict that small caps have room to rebound. Bank of America’s Jill Carey Hall, for example, has said segments of the market that have been pricing in the risk of a recession are most likely to outperform if the economy continues to grow.

Yet short sellers are still piling in. In the last 30 days, they have plowed $658 million into bets against small caps, an increase from the previous month, according to S3. The group has put the most money in bets against Archer Aviation Inc., Air Transport Services Group Inc, Alteryx Inc. and Sage Therapeutics Inc. in the last month, S3 data show. The most profitable small-cap short trades so far this year are beaten-down regional banks. Bets against Lumen Technologies Inc., Foot Locker Inc. and Beam Therapeutics Inc. also paid off, according to S3.