Small-cap stocks in the US are rising strongly, will hedge funds suffer heavy losses from shorting?

In the first half of this year, the tech giants led the US stock market, contributing to the main gains of the S&P 500 index, while small-cap stocks became the short targets of hedge funds. However, this trend seems to be reversing.

Overnight in the US stock market, due to the continued significant slowdown in CPI data, small-cap stocks collectively surged, with investors starting to sell leading large-cap tech stocks and turning to small-cap stocks, mid-cap stocks, and interest rate-sensitive sectors such as real estate. The Russell 2000 index rose by 3.6%, while the tech-heavy Nasdaq Composite Index fell by 2%. This contrast is the largest on record. Many funds were forced to quickly close out short positions in small-cap stocks and reduce long positions in tech giants.

This change caught many hedge funds and investors off guard. According to analysis by Bespoke Investment Group, in the past five weeks, hedge funds and other investors significantly increased their short positions in the Russell 2000 small-cap index, with net short positions expanding by 9.5 percentage points to 16.8%. This is the largest five-week increase since March 2020.

The reason behind the surge in small-cap stocks overnight is very simple: rate cuts help increase the returns of small-cap stocks and enable these companies to better manage their debt.

June CPI data shows that US inflation has cooled significantly beyond expectations, with overall CPI month-on-month growth turning negative for the first time in four years, and core year-on-year growth hitting a new low in over three years. Expectations for rate cuts for the year have significantly increased, with the likelihood of a first rate cut in September rising to 80%, and the probability of a rate cut in July reappearing.

Jordan Irving, portfolio manager at Glenmede Investment Management, told the media that based on current valuation levels, small-cap stocks have much greater upside potential than large-cap stocks. Data from FactSet shows that the price-to-sales ratio of Russell 2000 index constituents is 1.2 times, while that of S&P 500 index constituents is 3 times.

So far this year, small-cap stocks have risen by less than 6%, while the overall US stock market has risen by over 15% during the same period.

Callie Cox, Chief Market Strategist at Ritholtz Wealth Management, told the media that the rotation of stock market winners in 2024 has caught the entire market by surprise.

Analysis from Jefferies shows that in the first year after the Fed starts cutting rates, small-cap stocks tend to outperform large-cap stocks. Rate cuts may help boost the profits of small companies and improve their debt management capabilities. With the increasing expectations of rate cuts, small-cap stocks may see a larger scale of gains.

However, analysts also remind investors that rate cuts alone may not solve all the problems faced by small-cap stocks. Investors still need to focus on whether these companies can increase profits and invest in growth projects However, considering that the valuation gap between small-cap and large-cap stocks is at one of its historical highs, small-cap stocks may still be favored by investors looking for undervalued opportunities