Small-cap stocks are a portion of the U.S. equity market that most investors overlook, and short sellers are profiting by wagering against them.
By betting on a decline in the prices of small-, micro-, and nano-cap shares, the group has generated paper profits of nearly $13 billion this year, according to an estimate by S3 Partners LLC based on the average number of short positions in the market. This is in stark contrast to the approximately $140 billion in losses from short sales of mid-, mega-, and large-cap stocks, which rallied for the majority of the year as the economy defied gloomy forecasts, the Federal Reserve inched closer to ending its interest-rate hikes, and breakthroughs in artificial intelligence triggered a stampede in tech stocks.
The difference underscores the chasm 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 equities in the Russell 2000, an index of smaller companies, have declined this year, limiting the index’s gain to 5%, well below the S&P 500’s 16% increase.
“AI enthusiasm has driven a significant portion of this year’s performance, which has disproportionately benefited the largest tech stocks,” said Steve Sosnick, chief strategist at Interactive Brokers. It has been a succession of victors from the top down.
From June to July, the small-cap stocks joined the equity market rally. According to S3’s data, short-sellers have made an estimated $9.7 billion in profits since August as a result of the recent market decline.
Last week, investors withdrew $1.5 billion from segment-focused funds, the most in nearly three months, according to Bank of America Corp. strategists who cited EPFR Global. In contrast, US large-cap stock funds accumulated $5.5 billion in assets.
Rob Haworth, a senior investment strategist at U.S. Bank Wealth Management, attributed the underperformance in part to sector weightings that have stifled investor enthusiasm as they concentrate on specific industries. The group is underweight in technology, the best-performing sector of the market this year, and overweight in finance and energy, two of the worst-performing sectors. Small businesses are also the most severely impacted by economic slowdowns and monetary policy tightening.
“They also tend to bear the brunt of tighter credit conditions and stricter lending standards,” Haworth explained. “I think that’s kind of created this environment that’s put a lot of pressure on small caps.”
Mike Wilson of Morgan Stanley, who has been predicting a decline in the stock market, has similarly cautioned investors to avoid small-cap equities, whose profit margins are more susceptible to erosion by inflation.
S3 reports that less than 10% of all short selling consists of wagers against small-cap securities. And some analysts forecast that small-cap stocks have room to recover. Jill Carey Hall of Bank of America, for example, has stated that market segments that have priced in the risk of a recession are most likely to outperform if the economy continues to expand.
However, short sellers continue to pile in. S3 reports that in the last 30 days, investors have wagered $658 million against small-cap stocks, an increase from the previous month. According to S3 data, the group has wagered the most against Archer Aviation Inc., Air Transport Services Group Inc, Alteryx Inc., and Sage Therapeutics Inc. in the past month.
Regional banks have been the most profitable small-cap short wagers so far this year. According to S3, wagers against Lumen Technologies Inc., Foot Locker Inc., and Beam Therapeutics Inc. were also profitable.