In a surprising turn of events, hedge funds betting on a downturn in US and European stock markets have suffered staggering losses estimated at $43 billion amid a sharp rally over recent days. Short sellers, who had strategically positioned themselves against companies vulnerable to higher borrowing costs, found themselves on the wrong side of the market dynamics, facing a “painful” rebound in “low-quality” stocks.

The unexpected turn of events is attributed to the growing market confidence that the US Federal Reserve’s cycle of rate hikes may be coming to an end. Wall Street’s S&P 500 index is now on track for its strongest month since July of the previous year, propelled by Federal Reserve Chair Jay Powell’s perceived reluctance to tighten monetary policy further.

The rally gained momentum following weaker-than-expected US consumer price inflation data released last week, resulting in the S&P 500 and the tech-heavy Nasdaq Composite indices experiencing their best days since April. This upswing triggered a brutal “short squeeze,” forcing some hedge funds to repurchase stocks to cover their negative bets, further propelling share prices higher.

Data from S3 Partners revealed that hedge funds suffered losses of $43.2 billion on short bets in the US and Europe from Tuesday to Friday of last week. Short positions against technology, healthcare, and consumer discretionary stocks proved to be among the most costly for hedge funds, with some experiencing significant losses on individual stocks such as cruise line Carnival Corp.

Indices tracking heavily-shorted stocks have rebounded sharply, with Goldman Sachs’ Very Important Short Position index on track for its best month since October of the previous year. Barclays’ most shorted stocks in Europe basket also posted a notable 9.9% gain over the past three weeks, indicating its largest monthly increase in at least a decade.

The rapid market reversal has proven particularly challenging for trend-following hedge funds, known as commodity trading advisers (CTAs). These funds, which use algorithms and strict risk management metrics, have suffered as markets shifted direction, pricing in the possibility of additional rate cuts next year.

Despite the market upheaval, Barclays’ models suggest that CTAs remain net short on both equities and bonds. Charlie McElligott, a cross-asset strategist at Nomura, expressed surprise at the lack of dynamism in reversing the “higher for longer” trade, noting that hedge funds have missed out on November’s stock market gains in a “brutal fashion.” The current market conditions present a challenging scenario, with interest rates down and equities up remaining a “pain trade” for hedge funds.

Photo (Getty Images)

21st November, 2023
Delino Gayweh
Serrari Financial Analyst