The return of the market in 2023 was very bad news for one group: short sellers.
Short sellers profit from falling stocks by borrowing shares of companies they believe are overvalued, selling them back, and then buying them back at a lower price later. They made huge gains in 2022 when markets around the world fell.
But their fortunes reversed in January as the stock market recouped some of its losses.
A Goldman Sachs index that tracks the 50 best-selling stocks 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 also rose. You’re here Inc.,
TSLA 11.00%
just had its worst year on record, staged a 44% rally in January. Meanwhile, Cryptocurrency Exchange Losing Money Coinbase Global Inc.
PIECE OF MONEY 15.75%
is up 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 racked up $81 billion in mark-to-market losses on short positions this month through Thursday after racking up $300 billion in gains in 2022, Dusaniwsky said.
Investors and analysts say the rally appears to be driven by a few things. Signs of slowing inflation have fueled investor bets that the Federal Reserve will switch from raising interest rates to lowering as early as the second half of the year. This contributed to the rise in risky assets across the board. Particularly risky segments of the market, such as stocks with high short interest rates, rallied even more. Analysts say that likely forced short sellers to close bearish positions to cut their losses, leading to what Wall Street calls a short squeeze.
“We are seeing a mirror image of performance within the stock market. Last year’s underperformers have been leading this year,” said David Lefkowitz, head of US equities at UBS Global Wealth Management. “It looks like risk recovery and short coverage.”
Investors will get their next update from the Fed on Wednesday, when the central bank wraps up 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 in speculative assets could ease financial conditions 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 quick reversal, should the Fed prove more aggressive on monetary policy than investors expect.
“People are now more willing to assess the soft landing,” Lefkowitz said. “What I’m still struggling with is how is the Fed reacting to this? Can we really get inflation back to the Fed’s target if growth remains more robust than the markets thought it would be? just a few weeks ago?
Investors who have become more optimistic about the market outlook say the data suggests their worst-case scenario, a deep and prolonged recession, looks less likely than before.
So far, the US economy has been resilient in the face of multiple rate hikes. Gross domestic product rose 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 economists had expected.
Investors are also pointing to the strength of the US labor market and the reopening of China as reasons for the change in market fortunes so far this year. For investors looking to pull capital out of the defensive positions that were so popular in 2022, the struggling tech sector has been a favorite starting point.
Even after its recent rally, the Nasdaq Composite looks cheap relative to its valuation during the pandemic rally, trading at a multiple of around 22 times earnings over the past 12 months, according to FactSet. This compares to a recent peak valuation of almost 37 times earnings in February 2021.
“We think there’s a lot of relative value in how some of these mega-tech companies have been beaten in 2022,” said Nicole Webb, senior vice president and financial adviser at Wealth Enhancement Group.
Ms. Webb added that tech stocks look attractive as they are likely to benefit particularly if the Fed begins to ease monetary policy.
Traders in interest rate derivatives markets see a 92% chance 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 by December, although Fed officials have indicated that they do not expect any rate cuts this year.
Bond traders are also betting that the Fed will cut rates. The 10-year Treasury yield fell to around 3.5% after a recent high of 4.2% in October.
The decline in bond yields was good news for technology stocks in particular. Tech stocks often promise big profits, but only in the future. This means they tend to do better when rates are low and investors have fewer simple options to earn yield. They are often considered to have high duration risk, which means that they are very sensitive to interest rates over time.
“A lot of these rising stocks were very short and long stocks with earnings far into the future. With a significant drop in the discount rate, those earnings are now worth more,” said Sameer Bhasin, director of Value. Point Capital, a New York-based family office.
Still, other investors remain skeptical of Goldilocks’ view that the Fed can rein in inflation and dampen policy tightening without inflicting more pain on markets.
“I think the inflation scars are too big today for them to feel comfortable cutting rates,” said Jason Brady, managing director of Thornburg Investment Management.
Fed Chairman Jerome Powell said the central bank wanted to avoid repeating its mistake of the 1970s, when policymakers cut rates too soon, leading to a prolonged period of runaway inflation and uneven growth. .
“When they cut rates, it will be because there is real weakness in the economy,” Brady said.
Write to Jack Pitcher at jack.pitcher@wsj.com and Akane Otani at akane.otani@wsj.com
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